It is vital to the success of enterprises that employees understand the basic idea of depreciation. After all, depreciation is a foundational concept in tracking financing and accounting business transactions.
Every department, regardless of size, needs to employ and account for depreciation, particularly if that department manages assets such as laptops, servers, or production machinery. How else are you going to know when it is time to purchase new equipment?
This smart person's guide explains what computer hardware depreciation is, how it works, and how to apply it in your business.
- What is it? In business, depreciation measures how much and how fast an asset loses value.
- Why does it matter? Depreciation allows businesses to express the results of their financial transactions more fairly and accurately.
- Who does it affect? Depreciation will affect any IT professional charged with acquiring, configuring, deploying, maintaining, and eventually replacing hardware, fixtures, vehicles, and other assets.
- How do you calculate depreciation? Most enterprises follow the guidelines formulated by the Generally Accepted Accounting Principles (GAAP). Businesses in the US will also have to calculate depreciation based on the U.S. Tax Code, which allows businesses to take advantage of accelerated depreciation as specified by the Modified Accelerated Cost Recovery System (MACRS) rules. Under certain circumstances, enterprises may elect to depreciate assets based on activity.
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What is depreciation?
Mention depreciation in a conversation, and you are likely to see your companion's eyes glaze over as they tune out and retreat to their own thoughts. But that reaction is somewhat misplaced—depreciation is not a hard concept to grasp. To put depreciation in its most simple terms: The more you use something, the less valuable it becomes.
In business, depreciation measures how much and how fast an asset loses value. As the value decreases, the business can deduct that amount as an expense against revenue.
In most cases, depreciation is applied to assets with a useful life of more than one year; these are typically big-ticket items like vehicles, production equipment, fixtures, and buildings. Businesses do not depreciate the cost of box of paper clips, for example, even though the box may last more than a year.
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Why does depreciation matter?
Depreciation allows businesses to express the results of their financial transactions more fairly and accurately.
Consider this example: Company A buys a new piece of equipment, the Widget, for $100,000. The Widget has a useful life of 10 years. Without depreciation, Company A would show $100,000 in expenses in the first year and no other expenses relating to the Widget for the next nine years.
Using the concept of depreciation, Company A would instead record the Widget as an asset on the balance sheet and slowly expense it over the 10 years. Spreading the expense of the Widget over its useful life paints a more accurate picture of its value to the business.
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Who does depreciation affect?
Any manager, department head, network administrator, or other IT professional charged with acquiring, configuring, deploying, maintaining, and eventually replacing hardware, fixtures, vehicles, and other assets with a useful life of more than one year must understand depreciation. The concept of depreciation, and of spreading the expense of equipment over its useful life, is vital to proper budgeting and financial reporting.
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How do you calculate depreciation?
Most enterprises follow the guidelines regarding depreciation formulated by the Generally Accepted Accounting Principles (GAAP). The GAAP provisions were established by the Financial Accounting Standards Board (FASB), which creates the agreed upon framework for all financial transactions. By adopting GAAP, all enterprises can speak the same "financial reporting language," simplifying measurement and making universal comparison possible.
Businesses residing in the US will also have to calculate depreciation based on the U.S. Tax Code, which allows businesses to take advantage of accelerated depreciation as specified by the Modified Accelerated Cost Recovery System (MACRS) rules. By accelerating the "expense" of a depreciable asset, enterprises can reduce income taxes in the early years of an asset's useful life.
Under certain circumstances, enterprises may elect to depreciate assets based on activity. This method is generally employed for production machinery, where the useful life of the equipment can be directly tied to the number of units it produces. In other words, if a machine's useful life is 10,000 Widgets, if may be more accurate to depreciate on the number of Widgets produced rather than how many years it will take to produce those units.
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Whether you use GAAP, MACRS, or activity, the calculation of depreciation for an asset requires the same set of variables:
- Cost of the asset
- Useful life of the asset or number of units it will produce
- Salvage value at the end of its useful life
With that information, you can calculate how much to depreciate an asset each year over its useful life. Here's an example:
Company A purchases a building for $200,000 on June 1, 2017. The useful life of the building is 20 years. Using the Straight-Line method as prescribed by GAAP, divide the cost ($200,000) by the useful life (20 years) to determine the annual depreciable value of $10,000.
Depending on the asset and when it is placed into service, the calculation under GAAP can get more complicated. And, it becomes even more complicated when an enterprise uses MACRS for its income tax returns.
The most common methods for calculating depreciation are:
- Straight-Line method: This is the simplest and most common method—just divide the cost by the number of useful years.
- Declining balance method: Instead of spreading the depreciation over the useful life, the asset is depreciated at a specific rate each year of the useful life. The rate stays consistent but the remaining cost of the asset declines each year.
- Sum-of-the-years'-digits method: This is an accelerated method that is much less common, but it is still viable for certain assets. First, add the number of useful years together to get the denominator (1+2+3+4+5=15). Then, depreciate 5/15 of the asset's cost the first year, 4/15 the second year, etc.
- MACRS: This method is codified by the U.S. Tax Code, and all of the calculations are based on the asset class. The tax code specifies which class an asset qualifies for and then prescribes a useful life and depreciable percentage for that asset.
Calculating depreciation can get complicated to do by hand, which is why it's recommended to use a tool that can calculate depreciation for you. A simple, but effective, Computer Hardware Depreciation Calculator is available as an Excel download. It is not as sophisticated as an expensive asset management application, but it will do the job in a pinch. Note: For the most accurate planning values, you should consult your accountant.
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Mark W. Kaelin has been writing and editing stories about the IT industry, gadgets, finance, accounting, and tech-life for more than 25 years. Most recently, he has been a regular contributor to BreakingModern.com, aNewDomain.net, and TechRepublic.