Fixed Asset Depreciation: Here's What You Need to Know

May 30, 2024

Understanding fixed asset depreciation is crucial for any business aiming to optimize financial performance and maintain compliance with accounting standards. In this blog, we’ll demystify the complexities surrounding the depreciation of fixed assets, providing you with the essential knowledge to better track and manage your company’s valuable resources.

Whether you're a seasoned finance professional or new to fixed asset management, this guide will equip you with the insights needed to enhance your organization’s asset tracking and financial planning.

Main Takeaways from This Article:

Understanding and applying the concept of fixed asset depreciation is crucial for accurate financial statements and tax reporting.
The different methods of fixed asset depreciation are straight-line, declining balance, double-declining balance, sum-of-the-years' digits, and units of production, which provide flexibility based on your company’s specific circumstances.
Each depreciation method comes with its unique step-by-step process, from the identification of the asset to the recording of the depreciation expense.
Estimating salvage value, an essential aspect of depreciation calculations can be achieved through history, professional appraisal, or percentage estimates.
When claiming depreciation deductions, adhere to regulatory requirements by following IRS guidelines, applying accounting standards, using depreciation schedules, and avoiding common compliance mistakes.
In your financial statements, depreciation gets entered as an expense on income statement and a noncurrent asset on your balance sheet.
Depreciation yields tax savings that can be multiplied by applicable immediate expense deductions.
Combining RedBeam's fixed asset tracking software with recordkeeping best practices enables you to automate your depreciation calculations.

What Is Fixed Asset Depreciation?

Fixed Asset Depreciation refers to the gradual decrease in the value of tangible assets over time due to factors such as wear and tear, obsolescence, or aging. This decline in value is systematically recorded in a company's financial statements to accurately reflect the asset's reduced worth over its useful life. Depreciation is a non-cash expense, meaning no physical money is exchanged, but it impacts a company's profitability and tax obligations.

Businesses track asset depreciation to claim tax deductions and improve financial reporting and planning. Tax regulations allow you to claim depreciation as a type of deductible expense and spread your deductions out over the lifetime of the asset. Tracking depreciation also gives you a clearer picture of the value of your asset and a better estimate of what you'd need to pay to replace it.

Fixed Assets vs. Intangible Assets

Fixed assets and intangible assets are both crucial components of a company's balance sheet, representing valuable resources that contribute to its operations and potential for future growth. However, they differ in nature, characteristics, and treatment in financial accounting. Here's a breakdown of their distinctions:

Fixed Assets

Tangible Nature: Fixed assets are physical assets with a definite, measurable value and a finite useful life.
Examples: Common examples include land, buildings, machinery, vehicles, and equipment.
Acquisition Cost: Fixed assets are typically acquired at a cost that includes purchase price, installation, and any other expenses necessary to make the asset ready for its intended use.
Depreciation: These assets undergo depreciation, where their value gradually decreases over time due to wear and tear, obsolescence, or other factors.
Financial Reporting: Depreciation expenses associated with fixed assets are recorded on the income statement, while the asset's carrying value is reported on the balance sheet.

Intangible Assets

Non-Physical Nature: Intangible assets lack physical substance and are typically intellectual property or rights.
Examples: Examples include patents, trademarks, copyrights, goodwill, and software.
Valuation: Determining the value of intangible assets can be challenging, often requiring valuation techniques such as market approach, income approach, or cost approach.
Amortization: Similar to depreciation, intangible assets undergo amortization, where their value is systematically reduced over their useful life.
Financial Reporting: Amortization expenses related to intangible assets are recorded on the income statement, while the asset's carrying value is reported on the balance sheet.

With these differences in mind, let's explore essential methods to calculate depreciation of fixed assets.

Common Fixed Asset Depreciation Methods

Straight-Line Method

The straight-line depreciation method distributes the initial cost of fixed assets evenly throughout their expected useful life. This technique calculates the annual depreciation expense by dividing the asset's initial purchase price by its predicted period of functionality. With each passing year, a uniform amount is pared down from the asset's total value, resulting in a steady decrease over time.

Declining Balance Method

The declining balance method of depreciation represents an accelerated depreciation approach that proportionally assigns a fixed percentage of the remaining book value of a tangible asset to each fiscal year. This method underscores a greater depreciation expense during the asset's initial operational years, with these charges gradually diminishing as the asset ages.

This method offers efficacy, particularly for assets such as state-of-the-art technology or advanced machinery, which tend to depreciate more quickly during their initial operational years.

Double-declining Balance Method

The double-declining balance method follows an accelerated approach similar to the declining balance method but doubles the rate of decline. This method doubles the product of the book value at the beginning of a period times a straight-line depreciation percent.

Companies use this method with assets that lose their value or become obsolete quickly, such as computers and smartphones.

Sum of the Years' Digits Method

The sum-of-the-years' digits method is a depreciation approach that assigns a considerably larger portion of an asset's depreciation value towards the beginning stages of its lifecycle. In essence, this is an advanced technique that calculates yearly depreciation costs by applying a unique fraction to the total depreciable cost of the asset. This ratio is determined by adding all the numbers that compose the complete useful life of the asset.

This method stands out because it is fast. It quickly accounts for depreciation expenses, making it the go-to choice for assets that experience a steep drop in value during their earlier life stages.

Units of Production Method

Unlike other depreciation methods that rely on time, this technique concentrates on the actual output or utilization of an asset. The depreciation expense is allocated primarily based on the asset's actual use, such as the number of miles driven for vehicles or the operational hours for machinery.

What sets the units of production depreciation method apart is its precise reflection of the asset's wear and tear over time.

How to Depreciate Fixed Assets Step-By-Step

Now that you know how to calculate the depreciation of fixed assets, take a look at our comprehensive step-by-step approach. From determining asset cost to selecting the depreciation method, we'll walk you through each crucial stage.

1. Identify the Asset

The first step toward depreciating your company's fixed assets is to identify each asset specifically. This is more than simply knowing what the asset is; it involves a comprehensive understanding of its features and attributes. By following these simple steps, you can make this process efficient and error-free:

Itemization: Make a detailed list of each of the fixed assets. Include everything from office equipment to buildings.
Description: Include a detailed description for each asset. Indicate the type, model, make, serial number, and other details that make it unique.
Purchase Details: Record the date and price of purchase. This information is crucial when calculating depreciation.
Location: Track where each asset is located within your organization. This will facilitate asset tracking and manageability.
Asset Condition: Regularly assess the condition of the asset. The asset's condition might impact its depreciation rate and its future resale value.
Associated Documentation: Gather all related documents, such as purchase orders, warranties, and maintenance records. These documents help identify the asset and are invaluable during audits or asset disposal.

2. Determine the Asset's Useful Life

The useful life of an asset refers to the period over which an asset is expected to be usable, providing economic benefits to the business. Here's how you can go about achieving this step:

Industry Standards: Different industries often have standard asset life cycles. Doing a quick search or asking other businesses within your industry can provide a good starting point.
Manufacturer Guidelines: Oftentimes, the manufacturer provides guidelines on how long an asset is expected to last. This information can be pulled from the product manual or warranty document.
Company Experience: Past experiences within the company with similar assets can be leveraged. Historical data may offer insights into the average lifespan and depreciation rate of an asset.
Professional Assessment: If it’s difficult to determine the useful life, you can consult with a professional evaluator. They will do an in-depth assessment of the asset, evaluating all factors that may affect its lifespan.

3. Calculate the Depreciable Base

This calculation forms the cornerstone of any depreciation schedule and predicts the amount your asset will depreciate over its expected lifespan. We have broken down the process for you in a few simple steps:

Determine the initial cost of the asset: This is the purchase price or production cost of the asset, including all costs needed to acquire it and make it ready for use. For example, these costs can be insurance during transport, installation expenses, and sales tax.
Estimate the salvage value: This is a prediction of what an asset may be worth at the end of its useful life. Predominantly, this is an estimated selling price, particularly in the context of an asset that can be resold once its usefulness to your business has ended.
Calculate the depreciable base: Subtract the salvage value from the initial cost of the asset. The result is the depreciable base or the total amount of an asset that is to be depreciated over time.

4. Select the Correct Method of Depreciation

Choosing the correct depreciation method ensures accurate asset values over time. This choice should reflect the usage, wear and tear, and life span of the asset. Here are some key points to keep in mind:

Usage Review: Prioritize methods like the units of production method if the asset's usage significantly impacts its value decline.
Economic Factors: Consider economic conditions like inflation or market trends, possibly advantaging declining balance methods.
Company Policy: Company policies may have predetermined methods. Ensure that these align with your asset's characteristics and GAAP standards.
Regulatory Compliance: Stay compliant with regulatory requirements, like tax norms, which might influence the selection.
Financial Reporting: The method you select will affect your balance sheet, income statement, and cash flow statement. The straight-line method, for instance, provides consistency, making financial forecasting more manageable.

Consider these factors in your decision-making process to ensure a practicable depreciation strategy. When in doubt, consult a financial advisor or use specialized software like RedBeam to guide you in the right direction.

5. Apply the Depreciation Formula

The application of the formula will vary depending on the type of depreciation method chosen. So, let's look at each method and its formula for a clear understanding:

Straight-Line Method: Depreciation Expense = (Cost of Asset – Salvage Value) / Useful Life. The same amount is depreciated each year over the asset's useful life.
Declining Balance Method: Depreciation Expense = Book Value at the start of the year * Depreciation rate. The rate is greater than that used in the straight-line method, which results in larger depreciation expenses during the early years of an asset's life and decreases over time.
Double-declining Balance Method: Depreciation Expense = Book Value at the start of the year * Depreciation rate * 2. This doubles the declining balance method for even more accelerated depreciation.
Sum of the Years' Digits Method: Depreciation Expense = (Cost of Asset – Salvage Value) * (Remaining Life / Sum of The Years’ Digits). This approach provides accelerated depreciation, wherein the expense is higher in the earlier years and lower as the asset ages.
Units of Production Method: Depreciation Expense = (Cost of Asset – Salvage Value) / Total Units Expected to be produced. This method ties the depreciation charge directly to the level of asset usage.

Understanding and applying these formulas will help calculate asset depreciation appropriately, thereby ensuring that asset values on your balance sheet remain accurate.

6. Record the Depreciation Expense

Recording depreciation expenses accurately is essential for a clear picture of the asset's worth over time and for informed decision-making. Here's how you can keep accurate records:

Journal Depreciation Expense: Start by recording your depreciation expense in the company's financial journal. This entry reflects how much value the asset has lost over a specific period, typically over a month or a year.

Adjust the Carrying Value: The carrying value is the original cost minus any accumulated depreciation. It's important to adjust this in your records regularly.

Revaluate Regularly: Monitor the asset's depreciated value. This periodic check ensures your records are accurate, adjusts for any methodological changes, and salvages value if the asset is sold prematurely.

Tax Considerations: Ensure your records reflect the correct depreciation expense, as this will impact the business's taxable income. Incorrect or omitted entries may lead to disparities, potentially resulting in financial penalties.

Year-End Accounts: At the end of the fiscal year, transfer the year's accumulated depreciation from the income statement to the balance sheet's accumulated depreciation account.

Fixed Asset Depreciation and Compliance

When calculating and claiming depreciation deductions, you must follow guidelines set by government regulatory agencies and industry standards boards. Adhering to best practices such as creating depreciation schedules will help you avoid common mistakes.

IRS Guidelines for Asset Depreciation

IRS guidelines allow you to claim a depreciation of property deduction for qualifying property you place in service for a trade or business or to generate income. You can start claiming the deduction when you place the property in service. You can continue claiming it when you've fully covered the cost or other basis or you've retired it from service, whichever comes first.

You can claim depreciation for non-personal assets in these categories:

Machinery
Equipment
Furniture
Buildings
Vehicles

You can't claim depreciation for land, but you may be able to claim depreciation for buildings and improvements to land.

You can't claim depreciation for personal property. If you use property for both personal and business purposes, you can only claim depreciation for the portion used for business or investment.

To qualify for depreciation, property must meet all these requirements:

Your business owns the property, even if you're still paying it off.
You use the property for business or taxable income-producing activity.
You can assign the property a determinable useful life, meaning you expect it to wear out over time.
You expect the property to last more than a year.
Your property doesn't fall under specific exceptions, including certain intangible property, certain term interests, equipment used for capital improvements, and property disposed of in the same year you enter it into service.

You can use IRS Form 4562 to calculate depreciation deductions.

GAAP vs. IFRS Depreciation Rules

When calculating depreciation deductions, you can use one of the accounting standards recognized by accounting bodies and regulatory authorities. In the United States, the default standard is Generally Accepted Accounting Principles (GAAP), while many other countries follow the International Financial Reporting Standards (IFRS). GAAP uses a rules-based approach with many industry-specific requirements, while IFRS follows a principles-based method with more general scope, although recent updates have narrowed these distinctions.

With respect to depreciation, GAAP rules mandate that fixed assets are valued at their historic cost and depreciated accordingly. Components of assets with lifespans differing from their assets can be depreciated separately, but GAAP does not mandate this.

IFRS principles prescribe that fixed assets should be valued at cost initially and afterward can be revalued to market value. Components with different lifespans than their assets must be depreciated separately.

Depreciation Schedules and Reporting Requirements

A depreciation schedule helps you calculate how much depreciation to claim each year over the lifespan of your assets. It typically records the following information about each of your assets:

Name and description
Purchase date
Cost
Estimated lifespan
Salvage value (residual value)
Current year depreciation
Accumulated depreciation up to a given year
Depreciation method used
Net book value

You must report depreciation. If you don't claim depreciation deductions, when you dispose of your asset, tax authorities will assume you claimed your deductions anyway, so you'll have more gains to report without enjoying deductions you could have claimed.

Common Compliance Mistakes and How to Avoid Them

If you're not used to calculating depreciation, it's easy to make mistakes. Here are some of the most common mistakes and how to avoid them:

1. Failing to Report Depreciation

Mistake: You might avoid reporting depreciation because it seems too complicated, costing you deductions and leaving you with more tax liability when you dispose of the asset.
Solution: Treat depreciation reporting as mandatory.

2. Trying to Calculate Depreciation Yourself

Mistake: You might be tempted to save money by doing your own accounting and taxes, leaving yourself open to making mistakes with depreciation calculations.
Solution: If you're not experienced with accounting and depreciation calculations, hire a professional.

3. Failing to Use Software to Calculate Depreciation

Mistake: If you use manual methods or spreadsheets to calculate depreciation, you increase your risk of data entry errors, calculation errors, and incorrect formula usage.
Solution: Use a software program with depreciation calculation tools built in.

4. Using the Wrong Depreciation Method

Mistake: If you fail to select a depreciation method suited to your asset type, it can prevent you from maximizing deductions.
Solution: Select a depreciation method which takes into account how quickly you expect your asset to lose its value.

5. Misclassifying Assets

Mistake: If you don't follow the regulatory guidelines applicable to your asset type (such as buildings vs. vehicles), you can miscalculate your depreciation deductions.
Solution: Follow the guidelines on how to depreciate properly published by the IRS.

6. Failing to Update Fixed Asset Values

Mistake: If you misestimate an asset's useful life, you can miscalculate depreciation.
Solution: Regularly review asset useful life estimates based on actual usage.

If you find you've made mistakes in calculating depreciation, you may be able to file an amended return or a change in accounting method form.

7. Neglecting Maintenance Costs

Mistake: If you fail to estimate the cost of maintaining an asset, you can underestimate its total cost.
Solution: Include maintenance estimates, which can be calculated automatically with software.

8. Neglecting Salvage Value

Mistake: If you forget to account for the residual value you recover at the end of an asset's lifespan, you can overestimate its depreciation.
Solution: Include salvage value estimates in your depreciation calculations.

Fixed Asset Depreciation and Financial Statements

How do you handle fixed asset depreciation on your financial statements? Here's where to enter it:

On your income statement, report fixed asset depreciation as an expense. Depending on your industry and business model, depreciation may be listed as an operating expense, or if the asset relates to production, it may be listed under cost of goods sold.
On your balance sheet, report accumulated depreciation as a contra account under non-current assets.
On your cash-flow statement, report depreciation in your cash flow from operations section under additions to cash.

Your accountant can help you verify that you've entered the information correctly.

Fixed Asset Depreciation for Tax Purposes

For tax purposes, fixed asset depreciation deductions translate into tax savings. Depreciations reduce your taxable earnings, lowering your tax liability. You can incorporate depreciation into your tax planning strategy by choosing depreciation methods aligned with your financial strategy.

Bonus Depreciation and Section 179

Tax law currently allows businesses to use two methods to claim immediate expense deductions in the first year of depreciation:

Bonus depreciation
Section 179

Bonus depreciation, currently set to be phased out, allows companies to claim a large percentage of an asset's cost during the year of its purchase. Set at 100% in 2022, the percentage has dropped 20% a year since then, standing at 40% in 2025 and placing it on track to reach 0% by 2027.

Section 179 allows businesses to deduct a set dollar amount rather than a percentage. Depreciation deductions under Section 179 have an annual cap limit and cannot exceed annual taxable income.

Some businesses may be eligible to claim both bonus depreciation and Section 179 deductions in the same year.

Fully Depreciated Assets

Fully depreciated assets have reached the end of their useful life, making their value equal to their cost or salvage value. You don't report any additional expense on your income statement for fully depreciated assets, but they remain on your balance sheet until the asset gets disposed of.

How to Track and Manage Fixed Asset Depreciation Efficiently

The key to tracking fixed asset depreciation efficiently is combining efficient software with best practices. You can use asset tracking software to digitally enter depreciation data about each asset, based on manufacturer useful life estimates. Once you've entered this information, your software can automatically calculate depreciation.

Best Practices for Keeping Accurate Depreciation Records

To keep your fixed asset depreciation records accurate:

Keep records of all fixed asset purchases and sales
Use barcode scanning to automatically enter purchased assets into your system with unique IDs
Classify assets by type to tag assets eligible for depreciation deductions
Apply the correct depreciation calculation methods to your assets
Use software to automatically calculate and update depreciation

Following these best practices will help you maximize the efficiency you gain from using fixed asset management software.

Optimize Your Fixed Asset Depreciation with RedBeam

RedBeam's cloud-based fixed asset tracking software provides you with the tools you need to calculate depreciation efficiently and accurately. RedBeam simplifies your asset tracking by letting you use barcode scanning to automatically enter asset information into a database you can access from anywhere.

For each asset, you can use our Assets tab to enter all the accounting data you need for automated depreciation calculations, including acquisition date, cost, and manufacturer estimate of recovery period. Once you enter this data, RedBeam can automatically calculate depreciation for you, instantly and accurately.

Try our 30-day free trial to experience how RedBeam can simplify your depreciation calculations and make your asset tracking easy.