Though it may seem intimidating, the concept of depreciation is fairly simple. To illustrate depreciation with an easy example, think of a car. Pretend you just purchased a new car for your business. You’ve probably heard that the car loses value “as soon as you drive it off the lot”. Though that seems a bit extreme, it’s actually true! Typically, we do not consider depreciation in such short time intervals, but the principle applies. As time passes, the value of your company car will depreciate, or decrease. The car is considered an asset to your business, and the correct accounting term for measuring the decrease in value of an asset is depreciation.
For the purposes of accounting, depreciation is listed as an expense on the income statement. Several assets of your business should be included in depreciation expenses. Examples of assets that should be depreciated include office furniture, office equipment (like a computer), buildings, and machinery used in manufacturing processes. Land, however, is not an asset that can be depreciated, as it does not “wear out” like a building.
In order to calculate annual depreciation, you must know the original cost of your assets. You also must consider the estimated life of the assets – how long it will be useful to your business. Let’s discuss a common method for calculation loss of value over time: straight-line depreciation.
To use the straight-line method of depreciation, you must first determine the initial cost of the asset and the estimated useful life. Let’s revisit the car example. Let’s say you purchase the company car for $15,000 and expect to use it for your business for ten years. To compute depreciation with the straight-line method, simply divide the initial cost by useful life.
Straight-line depreciation is considered to be the most common method of depreciating assets. To compute the amount of annual depreciation expense using the straight-line method requires two numbers: the initial cost of the asset and its estimated useful life. For example, you purchase a truck for $20,000 and expect it to have use in your business for ten years. Using the straight-line method for determining depreciation, you would divide the initial cost of the truck by its useful life. In this example, the company car would depreciate by $1,500 each year. Some accountants prefer to use different depreciation methods to record larger depreciation expenses in the first few years.