When purchasing fixed assets like buildings (not land), vehicles, equipment and machinery it’s important to determine what method of depreciation should be used as a tax deduction. Since asset depreciation is recorded as an expense on the income statement, it can have a profound affect on reported profits. This also has an impact on the balance sheet and net worth of the company.
Straight Line Depreciation Method
The straight-line depreciation method is the most common method. This method allows for equal depreciation over the life of the asset. Straight-line depreciation is also the easiest method to calculate.
- Determine the useful life of the asset in years
- Determine the salvage value of the asset after its useful life
- Deduct the salvage value from the purchase price of the asset
- Divide the number of useful years into the total in step number 3
As an example, assume an asset has a purchase price of $10,500. The asset has a useful life of five years. The salvage value after the assets useful life is $500.
- 5 years
- $500
- $10,000 ($10,000 - $500)
- $2,000 (5 years/$10,000)
In this example, using the straight-line method of depreciation, the total amount of depreciation is $2,000 a year.
Accelerated Depreciation Methods
There are other methods of depreciation that allows for larger depreciation amounts during the early life of the asset. Rapid depreciation is most useful when the asset is expected to generate larger incomes in the early life of the asset. This allows for greater tax deductions early in the assets life to offset the larger income that the asset produces.
Sum of the Year’s Digits – Accelerated Depreciation Method
The sum-of-the year’s digit method is calculated by adding the years together for a total sum that’s then used as a fraction for a given year. Using the same figures in the straight-line depreciation method of $10,500 purchase price, 5 years useful life and $500 salvage value.
- Add the sums of the year’s useful life 5 + 4 + 3 + 2 + 1 = 15
- Subtract the salvage value $10,500 minus $500 = $10,000
- The depreciation for the first year in fractions would be 5/15 or .333 rounded.
- The depreciation in the first year equals 5/15th of $10,000 or $3,333.
The second years would be 4/15th the third year 3/15th fourth year 2/15th and the final year of depreciation would be 1/15th of $10,000.
Another common method is the double declining balance method. Units-of-production depreciation is another method that’s more geared towards machinery output. There are many rules governing depreciation methods. Before choosing and implementing a certain method of depreciation, it’s always best to consult a certified public accountant (CPA) to discuss what options are best.
Source:
irs.gov
principlesofaccounting.com
James Clausen - Clausen received a Bachelors Degree in Business Administration in Automotive Management and Marketing at Northwood University, graduating ...
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