Businesses typically invest in office supplies, equipment, hardware, and other essentials to run their operations smoothly.
However, over time, the value of these fixed assets decreases with wear and tear, necessitating their replacement with more efficient equipment. The gradual decline in assets is recorded as depreciation that impacts a business’s financial health. Although, a business also has current assets, only fixed assets experience depreciation over time.
Understanding fixed asset depreciation is the key to improving your business’s financial worth, and adopting technology to better manage assets.This blog will simplify the way fixed asset depreciation works, and why depreciation is important for fixed assets.
What is fixed asset depreciation
Fixed assets, such as vehicles, heavy equipment, and machinery, are tangible in nature. They gradually decrease in value over time due to wear and tear – a concept known as fixed asset depreciation.
The decline of fixed asset value is recorded in the financial statements to evaluate the useful life of assets accurately. It can impact a business’s profitability and other tax obligations.
Why Depreciate a Fixed Asset
1. Display incurred expenses
Depreciation is a critical business expense that needs to be recorded in the financial statements to evaluate a business’s worth accurately. By recording the daily depreciation expense, asset managers can compare the expense with the revenue that fixed assets are generating. Without it, asset expenses can be overstated or understated, which distorts the true value of the assets.
2. Correct net book value
Are you interested in knowing the current value of the asset after one year of use? By calculating the depreciation of fixed assets, any business can easily determine its correct net book value.
For instance, you bought machinery for $50,000 and every three years the depreciable amount is $15,000. The net book value of the machinery will be $35,000. This information will help drive critical business decisions, including deciding when to dispose of an asset.
3. Recover the purchase cost
Businesses can recover the cost of the asset purchased with depreciation by utilizing the asset to its full capacity. The expenses are spread throughout the years instead of a single amount at once. If a business buys a tractor for $40,000, the entire amount will not be incurred in a year. Instead, the cost of the asset will spread over its useful life enabling businesses to maximize the value derived from that asset.
4. Tax deductible
A depreciation expense is tax-deductible. So, a business can lower its taxable income by showing the depreciation expense in the financial statements at the year-end. If a company reports a $5,000 vehicle depreciation, it will decrease the taxable income by that amount, leading to an increase in profit.
Methods to calculate depreciation of fixed assets
1. Straight-line depreciation method
Straight-line depreciation method is one of the most commonly used methods to calculate depreciation. The initial cost of the asset is equally divided throughout the expected useful life. To calculate the depreciation, you will need to divide the asset’s initial cost by the useful life.
2. Declining balance depreciation method
According to this method, a fixed percentage is applied to the remaining value of fixed assets each year. A new asset will have a higher depreciation when purchased but as it gets older, the depreciation amount will decrease.
3. Sum of the year’s digits depreciation
This method speeds up the process of depreciation while focusing on the initial cost of the fixed asset. A specific fraction is applied to the asset’s value each year. Larger amounts are usually covered at the beginning of the depreciation.
This method is suitable for fixed assets that lose their value quickly as compared to other assets. Common examples are tech-based equipment or vehicles. If you are implementing asset management automation, you can easily calculate the depreciation of your fixed assets.
4. Units of production depreciation method
This depreciation method is based on the number of units produced by an asset. So, the depreciation is calculated based on how productive the assets were for the business, instead of the number of years it has been owned.
For instance, the more a car has miles driven, the more its value will depreciate. This method solely focuses on the wear and tear of the fixed asset to give a more accurate picture of its value.
How to calculate depreciation on fixed assets
1. Identify the asset
A business needs to begin by identifying the fixed assets with the help of asset tags. It’s a comprehensive way to categorize fixed assets based on attributes and features. You can make the process hassle-free by:
- Tracking the fixed assets with fixed asset tracking software to compile the details about the location. Different tracking techniques will help you like GPS tags, barcodes, RFID tags, etc.
- Making a detailed list of fixed assets.
- Recording a detailed description of fixed assets like model, type, serial number, etc.
- Assessing the condition of each fixed asset used by the company that can impact the depreciation expense and asset value.
- Compiling all necessary asset documents such as licenses, purchase orders, maintenance records, etc.
- Creating asset reports to summarize the asset details.
2. Determine the asset’s useful life
The usefulness of a fixed asset is the expected period it can be used by the business. You can determine a fixed asset’s useful life in the following ways:
- Industries have a set standard for asset life cycles. Do research in your industry to become familiar with asset lifecycle management.
- Often manufacturers provide serial numbers, codes, and other guidelines indicating the useful years a fixed asset is expected to last. For instance, if you buy heavy-duty equipment it will come with a manual or other warranty document.
- Using the same type of asset repeatedly gives you an insight into the asset’s life and the expected depreciation expense. Therefore, asset monitoring allows you to keep tabs on asset movements with real-time insights.
3. Calculate depreciable base
It allows you to predict the depreciable amount of the fixed asset during its useful life. The process is simple and described below:
- If you have a proper system for asset control it is easy to identify the fixed asset’s initial cost, such as the installation cost, or production cost.
- You will also need to estimate the salvage value of the fixed asset. This focuses on when the asset’s useful life is expected to end, ultimately becoming the selling price.
- Subtract the salvage value from the initial cost of the fixed asset and you will be able to calculate depreciable cost.
4. Select depreciation method
Accurate asset values are guaranteed throughout time by selecting the appropriate depreciation technique. The selection ought to take into account the asset’s lifespan, usage, and wear and tear. The following are important things to remember:
- If the asset’s usage has a major impact on its value fall, give methods, like the units of production method, priority.
- Take into account factors such as market developments or inflation while evaluating falling balance strategies.
- There may be preset procedures for company asset management compliance. Make sure these are in line with the features of your asset and GDPR guidelines.
- Adhere to rules and regulations, such as tax laws, as they may affect the choice.
- The method you select will affect your balance sheet, income statement, and cash flow statement.
5. Apply depreciation formula
Choosing the right depreciation method depends on the type of fixed asset used. For instance, you will apply a straight-line method to calculate office furniture or buildings. For vehicles or IT equipment, you will apply the declining balance formula as it is more suitable for larger depreciation expenses.
6. Record depreciation expense
You can easily record a depreciation expense in the financial statement. The entry will reflect the lost value of the asset over the years. Here are the preferred ways to keep a record of depreciation:
- Keep a record of depreciation in the financial journal.
- You can adjust the carrying value of the fixed assets but it is crucial to maintain the records daily.
- The depreciation records must reflect the taxable income so that depreciation entries are not omitted mistakenly.
Optimize your fixed assets
Depreciation is a regular part and the most vital part of business financials. Think of depreciation as the financial lens that helps you predict the fixed asset value. Understanding the wear and tear of your fixed assets allows you to accurately track the financial statements and make more informed decisions.
You can manage all of your fixed assets, and record the depreciation by automating through EZOfficeInventory – an asset management software that enables you to track the fixed assets, easily calculate the depreciation, and keep track of all documents under one dashboard.
Stay on track with a hassle-free asset management system and optimize the value of fixed assets with ease.
