How to Calculate Depreciation on Equipment

Depreciation is an accounting method that allocates the cost of a tangible asset over its useful life. Businesses use depreciation to spread the expense of an asset, like equipment, across the periods it generates revenue. This process aligns the cost of an asset with the income it helps produce, providing a more accurate picture of a company’s profitability. It also serves a tax purpose, allowing businesses to deduct a portion of the asset’s cost each year, which can reduce taxable income.

Key Concepts for Depreciation Calculation

The depreciable basis of an asset represents the total cost that can be depreciated over its useful life. This basis includes the purchase price of the equipment, along with any costs incurred to get the asset ready for its intended use, such as shipping, installation charges, and testing fees. Subsequent improvements that extend the asset’s life or increase its capacity are also added to the depreciable basis.

The useful life of an asset is the estimated period over which it is expected to be productive for the business. This estimate can be based on industry standards, the company’s past experience with similar assets, or guidance from tax authorities like the Internal Revenue Service (IRS), which provides specific property classes for various types of assets under the Modified Accelerated Cost Recovery System (MACRS). For example, office equipment might have a different useful life than heavy machinery.

Salvage value, also known as residual value, is the estimated worth of an asset at the end of its useful life. The salvage value reduces the total amount that can be depreciated.

The placed-in-service date signifies when the asset is ready and available for its intended use. Even if an asset is purchased earlier, depreciation does not begin until it is physically ready and operational for business activities.

Standard Depreciation Methods

The straight-line method is the simplest and most commonly used approach, distributing the cost evenly over the asset’s useful life. To calculate straight-line depreciation, subtract the salvage value from the depreciable basis, then divide the result by the asset’s useful life in years. For example, equipment costing $10,000 with a $1,000 salvage value and a 5-year useful life would incur $1,800 in annual depreciation (($10,000 – $1,000) / 5).

The double-declining balance method is an accelerated depreciation method that recognizes more expense in the early years of an asset’s life. This method applies a fixed depreciation rate, typically double the straight-line rate, to the asset’s book value (depreciable basis minus accumulated depreciation) each year. For instance, with a 5-year useful life, the straight-line rate is 20% (1/5), so the double-declining rate is 40%. In the first year, $4,000 in depreciation would be recognized on a $10,000 asset ($10,000 40%). The depreciation calculation continues on the remaining book value, often switching to straight-line in later years to ensure the asset is fully depreciated down to its salvage value.

The sum-of-the-years’ digits method is another accelerated approach that results in a declining depreciation charge over the asset’s useful life. This method uses a fraction where the numerator is the remaining useful life of the asset at the beginning of the year, and the denominator is the sum of all the years’ digits of the asset’s useful life. For a 5-year asset, the sum of the years’ digits is 1+2+3+4+5 = 15. In the first year, 5/15 of the depreciable amount (cost minus salvage value) would be expensed.

The units of production method ties depreciation directly to an asset’s actual usage or output rather than time. This method is suitable for assets whose wear and tear depend more on activity levels than on the passage of time, such as manufacturing machinery. To calculate depreciation, determine the depreciation cost per unit by dividing the depreciable basis (cost minus salvage value) by the total estimated units the asset will produce over its life. Then, multiply this per-unit cost by the number of units produced in the current period. For example, if a machine costs $10,000, has a $1,000 salvage value, and is estimated to produce 100,000 units, the depreciation rate is $0.09 per unit (($10,000 – $1,000) / 100,000 units). If 10,000 units are produced in a year, the depreciation expense would be $900 ($0.09 10,000).

Special Depreciation Provisions

Section 179 of the Internal Revenue Code permits businesses to deduct the full purchase price of qualifying equipment and off-the-shelf software placed in service during the tax year, rather than depreciating the asset over several years. To qualify, the equipment must be tangible personal property used in the active conduct of a trade or business. This deduction reduces the depreciable basis of the asset to zero for tax purposes, meaning no further depreciation can be claimed on that specific portion. While there are annual limits on the total amount that can be expensed and phase-out thresholds based on the total cost of property placed in service, the core concept remains an immediate write-off. Businesses often elect this deduction to improve cash flow and reduce current tax liabilities, making it a valuable tool for small and medium-sized enterprises acquiring new or used equipment.

Bonus depreciation is another provision that allows businesses to deduct a significant percentage of the cost of qualifying new or used property in the year it is placed in service. This provision, often set at 100% in recent years, provides an immediate tax benefit. Unlike Section 179, bonus depreciation generally applies to a broader range of assets and does not have the same income limitation. When bonus depreciation is taken, the remaining cost of the asset after the bonus deduction forms the basis for any subsequent regular depreciation calculations. For instance, if 100% bonus depreciation is taken on a piece of equipment, its entire cost is expensed in the first year, leaving no remaining basis for future depreciation. This provision can be particularly beneficial for larger capital expenditures, providing substantial first-year tax savings.