Demystifying Depreciation
Depreciation can be a tough concept to explain. Accountants intrinsically know what it is and how to calculate it, but might have a hard time articulating it to a non-accountant.
Accounting is not an exact science sometimes. It can involve making estimates and it’s the accountant’s job to present a methodology to justify how these estimates are calculated. Depreciation is one of them. In short, depreciation is the amount of use or consumption of a long-term asset, expressed in dollars, for a specified period of time (e.g. monthly, annually).
The best example to use is a machine that makes the product you sell – we’ll call this fictitious product a widget. The machine cost $61,000. You don’t want to expense off the entire cost of the machine in the month of purchase because the machine will be in use and functional for an extended period of time and expensing it will skew your profit and loss for the month and artificially understate your net income. Instead, you capitalize it, making it a long-term asset on your balance sheet.
The first step in calculating depreciation is ascertaining the useful life of the machine. Since no one has a crystal ball, it is an estimate. There are two ways to determine useful life: 1) Anticipating how many years the machine will be functional without a major overhaul or 2) Estimating how many widgets the machine can produce before it “dies” or needs an overhaul. Method 1 is the most common method used. Method 2 requires another set of calculations, which is beyond the scope of this article. For this example, you determine that your widget-making machine’s useful life is 5 years.
The second step is to determine if the machine will have any value after you decide not to use it anymore and are going to dispose of it, another estimate called salvage value. After careful research, you determine that you wouldn’t be able to resell the machine as a functioning machine, but could get $1,000 for selling it as scrap. The $1,000 is your salvage value.
The third step is to subtract the salvage value from the cost of the machine. This is the amount you’re going to depreciate. In this case, it’s $60,000.
Last, you determine what method to use to depreciate the $60,000 over the 5-year useful life of the machine. The most common, and simplest, method to use is straight-line depreciation. For this example you divide the depreciable value ($60,000) by the number of months in the useful life (12 X 5 = 60 months), which comes out to $1,000 per month.
This $1,000 represents how much of the value of the machine you are using up or “consuming” each month.
This is a very simple example, aimed to illustrate the basic nuts and bolts behind depreciation. Please keep in mind that other depreciation methods might be better suited to your specific situation and that pros and cons exist for each method. Consult with your accountant to ensure the best method is being used for your organization.
The goal of this article is to help small business owners expand their understanding of depreciation better so they can develop a fuller comprehension of financial statements and make better-informed decisions for their venture. I welcome any comments or questions.