What is Depreciation?
Depreciation is the reduction in value of an asset that occurs with time and use, where the asset's value is expected to last more than one year, but not last forever (land is not considered to be a depreciable asset).
When you exchange cash for an asset, no immediate expense occurs because theoretically, you are simply exchanging one equal-valued asset for another. For example, if you were to exchange $10,000 cash for a machine valued at $10,000, theoretically you could immediately sell the machine for $10,000 without any loss.
However, if you were to use the machine in your business for a period of years before reselling, obviously the amount you could sell the machine for (salvage value) would be less than what you paid for it. And it's this difference (drop in value) between what you paid for the machine and what you end up selling it for that is the machine's actual depreciation expense.
Of course, since the machine's depreciation expense occurs over the span of two or more tax years, you need a systematic way to expense a portion of each year's depreciation to each tax year the machine is in service.
Straight Line Depreciation Method
While there are numerous methods for distributing an asset's depreciation expense over the course of its useful life, one of the most popular methods is called the Straight Line Depreciation Method (SLD) -- which, as the name implies, distributes the expense equally for each year of an asset's useful life.
To calculate an asset's straight-line depreciation expense, you first take the asset's acquisition cost and subtract the amount you think you could sell the asset for at the end of its useful life (salvage or residual value). The result is what is referred to as the asset's depreciable base.
Next, you divide the asset's depreciable base by the number of years you expect the asset to last. The result is the asset's annual depreciation expense.
The exception to the above is if the asset is first placed in service at any other time than at the beginning of the year. If that is the case, then the first year's depreciation expense is prorated based on what percentage of the year the asset was in service. Then, the remainder of the first year's partial depreciation expense is assigned to the final year of the assets useful life -- as shown in the example below.
Example of How to Calculate Straight Line Depreciation
Referring to back to the machine example discussed earlier, if you expect the $10,000 machine to last for 9 years, with a salvage value of $1,000.00, and you place the machine in service in April of 2012, here is how you would calculate the straight line depreciation expense for the applicable years.
|Step 1: $10,000 cost - $1,000 salvage value = $9,000 depreciable base|
|Step 2: $9,000 depreciable base ÷ 9 years of useful life = $1,000 annual depreciation expense|
|Step 3: 9 months in service ÷ 12 months = .75 of first year prorated|
|Step 4: .75 x $1,000 annual expense = $750 depreciation expense for year #1.|
|Step 5: $1,000 annual expense - $750 depreciation expense for year #1 = $250 depreciation expense for year #10.|
Here is the straight line depreciation schedule for the above example, as generated by the straight line depreciation calculator:
|Machine Depreciation Schedule|
In the last line of the depreciation schedule, you will note that the accumulated depreciation ($9,000) and the salvage value ($1,000) add up to the original cost of the machine.
Small Business Owners Beware!
In my 30-plus years of being a small business owner, I have seen a lot of small business start-ups fail simply because the small business owners had no formal knowledge of accrual-based accounting. In turn, this caused the owners to mistake excess cash as being spendable profit.
Of course, if a small business owner continues to spend profits that don't actually exist, eventually the business runs out of operating capital and fails.
And one of the most common causes for a small business running out of operating capital is the failure to set aside depreciation expenses as they accrue.
Using the $10,000 machine example, just because you are not writing a $1,000 check for the machine's depreciation on an annual basis, does not mean you have an extra $1,000 to spend. It means that you should be setting $1,000 aside each year so you can replace the machine at the end of its useful life -- without dipping into your operating capital.