I Love Depreciation
In fact, I love it so much that I keep track of depreciation on my personal finances to visualize and weigh the pros and cons of large, long-term purchases. It's a logical way to view and manage the value of your assets over time. Plus, depreciation is one of those basic accounting terms that you need to know if you're going to turn your business into an empire.
There are two ways of thinking about depreciation:
- Managing our asset values
- Tracking wear and tear
Long-term purchases are any item that benefit us for a long period of time. That car for $20,000 might deplete the bank account today, but it means that you have a car for several years. The cost of that car can be spread out during the years that it benefits you.
Another way of looking at depreciation is the wear and tear.
The car is an asset to you as soon as you buy it, so the value of $20,000 still belongs to you, it's just in a different form. However, the car will wear down over the course of time, and it's value will lessen. You can't sell it for $20,000 anymore. You can use depreciation to account for this loss of value over the course of the cars usefulness to you.
The IRS Loves Depreciation Too
Depreciation is an income tax deduction that allows a taxpayer to recover the cost or other basis of certain property. It is an annual allowance for the wear and tear, deterioration, or obsolescence of the property.
Generally, Variable Declining Depreciation is used for tax, with exceptions for items with lives over 7 years. The Internal Revenue Code contains an in depth description of the life of each item type.
My two favorite ways to calculate depreciation are:
- Straight line
- Variable depreciation
Straight Line Depreciation
Straight Line depreciation is the easiest to calculate, and the most straightforward.
Take the value, or cost of the item, and subtract the salvage value. Salvage value is the value of the item after it is used up. A car can still be sold for parts when it's no longer drivable, and a technology company might have no use for obsolete equipment that another company would pay for.
You divide this amount by the total number of years or periods that the item will be in use. This is the amount that you depreciate the item each year or period.
To go over Variable Depreciation, Double Declining Depreciation must be calculated first. Here's a chart that I've created as an example:
Double Declining Depreciation is an accelerated version of Straight Line.
To calculate Double Declining Depreciation, find the rate for Straight Line Depreciation, then double it. For every period, multiply the remaining balance of value for the item by the doubled rate. This sounds complicated, but it's not too bad.
To find the rate for Straight Line Depreciation, divide the number of periods the rate will span, normally one, by the total number of periods. If depreciating a car for 15 years, divide 1 by 15 to find the depreciate rate per year.
Part of the problem with Double Declining Depreciation is that it never completely depreciates the value. It's like taking half, then half, then half. There will always be a half left. For Double Declining Depreciation, often for the last period the remaining final value of the item is counted as depreciation instead of calculating a portion.
A version of Double Declining Depreciation is Variable Declining Depreciation.
Variable Declining Depreciation requires calculating the Double Declining Depreciation as described above, and also calculating a Straight Line Depreciation based on the remaining balance.
The idea behind Variable Depreciation is to use the depreciation method that produces higher depreciation.
This creates a depreciation method that uses Double Declining Depreciation until Straight Line Depreciation is higher, then uses Straight Line for the remaining periods.
And for all the calculus nerds, if you graph the remaining balance and the depreciation rate, one is the derivative of the other. So cool!