How to Calculate Your Depreciation Expense
Learn to accurately account for an asset's value over time. This guide covers the process for calculating and recording depreciation for financial and tax reporting.
Depreciation is an accounting method used to allocate the cost of a tangible asset over its useful life. The purpose of this process is to align the expense of using an asset with the revenues it helps to generate. This practice ensures that financial statements accurately reflect the consumption of an asset’s value as it contributes to business operations over time.
Information Needed to Calculate Depreciation
Before calculating depreciation, three pieces of information about the asset must be gathered. The first is the asset’s cost basis. This includes the purchase price and all expenditures necessary to bring the asset to a condition for its intended use, such as shipping fees, installation charges, and sales taxes.
The second piece of information is the asset’s useful life. This is an estimate of the period over which the business expects the asset to be productive, which is not necessarily how long it will physically last. Factors influencing this estimate include expected usage, technological obsolescence, and the company’s asset replacement policies.
Finally, the asset’s salvage value must be determined. Salvage value, also known as residual value, is the estimated amount a business could sell the asset for at the end of its useful life. The difference between the asset’s cost basis and its salvage value is the total amount that will be depreciated over its useful life.
Common Depreciation Calculation Methods
The most common approach is the straight-line method, favored for its simplicity. It allocates an equal amount of depreciation expense to each accounting period. The formula is: (Asset’s Cost Basis – Salvage Value) / Useful Life. For a machine costing $12,000 with a $2,000 salvage value and a five-year useful life, the annual depreciation would be ($12,000 – $2,000) / 5, which equals $2,000 per year.
Another approach is the declining balance method, an accelerated technique that records higher depreciation expense in an asset’s early years. The most common variant is the double-declining balance method, which doubles the straight-line depreciation rate. For the same $12,000 machine, the straight-line rate is 20% (1 / 5 years), so the double-declining rate is 40%. In year one, depreciation would be 40% of the $12,000 book value, or $4,800, without initially considering salvage value.
The units of production method ties depreciation directly to asset usage rather than the passage of time. This is suitable for equipment where wear and tear is the primary factor in its value decline. The formula is: ((Cost Basis – Salvage Value) / Estimated Total Production Capacity) Actual Units Produced. If the $12,000 machine is expected to produce 100,000 units in its life, the rate is ($12,000 – $2,000) / 100,000 units, or $0.10 per unit. If 15,000 units are produced in a year, the depreciation expense for that year would be $1,500.
Recording the Depreciation Expense
Once the depreciation amount for a period is calculated, it must be recorded in the company’s accounting records through a journal entry. The standard journal entry involves two accounts.
The first account is Depreciation Expense, which is debited. This account appears on the income statement and reduces the company’s net income. The second account is Accumulated Depreciation, which is credited. This is a contra-asset account paired with a related asset to reduce its value on the balance sheet.
The book value of an asset is its original cost minus the total accumulated depreciation recorded to date. As depreciation is recorded each period, the asset’s book value decreases. This process continues until the book value is reduced to its estimated salvage value.
Special Considerations for Tax Depreciation
For federal income tax purposes, businesses in the United States use the Modified Accelerated Cost Recovery System (MACRS) instead of the methods used for financial statements, often called ‘book depreciation.’ This system is mandated by the Internal Revenue Service (IRS) and has its own distinct rules.
Under MACRS, the IRS predetermines the useful life of an asset, referred to as the recovery period, based on the asset’s property class. The salvage value of an asset is not considered in the MACRS calculation; the entire cost basis of the asset is depreciated.
In addition to standard MACRS schedules, two provisions can accelerate tax deductions. The Section 179 deduction allows a business to expense the entire cost of qualifying equipment in the year it is placed in service, up to a specified limit. Bonus depreciation permits the immediate deduction of a percentage of an asset’s cost. For assets placed in service in 2025, the bonus depreciation rate is 40%, and this rate is scheduled to decrease to 20% in 2026 before being eliminated.
These tax depreciation rules are complex. Given the specific requirements and potential for tax savings, businesses should refer to IRS Publication 946, “How To Depreciate Property,” or consult a tax professional for guidance.