When a company purchases a fixed asset such as a piece of equipment or a computer, it uses depreciation to determine the life cycle value of the item. Depreciation is also how the company claims the item on its federal and state tax filings. Depreciation is the gradual loss of value the product experiences as it is used throughout its life. If a product exceeds its expected lifespan, then it becomes a valuable asset to the company. Calculating depreciation is a process that every company needs to understand.
The first step to calculating depreciation is to determine the asset’s depreciable cost. This is done by subtracting the salvage value from the purchase price. The purchase price is simply the amount of money the company paid for the asset. The salvage value is how much, in current dollars, the item will be worth when it reaches the end of its usable life and is scrapped. The formula is:
Depreciable Cost = Asset Purchase Price – Salvage Value
Most companies have complex formulas they use to determine salvage value, while others subscribe to companies that offer salvage value tables for a wide variety of items.
Establishing Usable Lifespan
Most companies take great pains to track how long their assets last, and that information is valuable in determining an asset’s usable lifespan. The usable lifespan relies on routine maintenance being performed and takes into account the necessity of regular repairs. For example, the company has learned from experience that the average desktop computer has a usable lifespan of eight years. After eight years, whether it is due to outdated technology or the demise of the unit, it must be replaced.
If an asset is new to a company, there are online resources that can be used to determine the asset’s usable lifespan. Some companies prefer to estimate usable lifespan based on their own needs. For example, the company purchased a new piece of equipment it has never purchased before but only needs to use the piece of equipment for four years. For this asset, the usable lifespan will be four years after which the asset will probably be sold.
Calculating Depreciation Per Year
The formula for calculating depreciation per year is:
Depreciation Per Year = Depericable Cost / Usable Lifespan
For example, let us say that the depreciable cost of a desktop computer is $800. Since we already determined that its usable lifespan is eight years, we know that the depreciation per year is $100. This is the number used by the company on its state and federal tax filings each year.
The number of years that a company can claim an asset’s depreciation on a federal tax filing depends on the asset. Most farm equipment can be claimed for three years, computers and office equipment can be claimed for five years and miscellaneous office furniture and equipment can be claimed for seven years. Depreciation is a good way for businesses to get a tax benefit from the equipment they purchase and use on a regular basis.