When you spend a lot of money on a piece of heavy equipment like an excavator, you expect it to make you money. However, as the years go by, the excavator you originally purchased is no longer the newest model; now there are better models that have newer features and make the work easier and increase productivity. Construction equipment, like any other asset, loses value with age; this loss in value is typically referred to as depreciation.
While it may seem like a bad thing, there’s a lot more to the depreciation of construction equipment than initially meets the eye. With a little bit of strategy, depreciation can be a valuable way to mitigate taxes on the profit your business generates. Keeping accurate track of depreciation is also a smart business move, because for accounting purposes, it gives you insight into what your equipment is actually worth and allows your accountant to accurately determine what your balance sheet looks like.
Depreciation is the gradual loss of value of equipment over time. It allows businesses to deduct the declining value as an expense to lower taxable income.
There are different methods of calculating depreciation, including straight-line, sum-of-years, and declining balance.
Tracking depreciation accurately portrays the real value of equipment assets on a business’s balance sheet over time. This helps with accounting and making decisions about when to replace aging equipment.
In this Article
What is Equipment Depreciation
Equipment depreciation is simply a way of looking at an asset purchased for a fixed price and recognizing that the asset will not be worth the same amount of money after a certain period of time. This can be through wear and tear or because there are newer, more functional models of equipment that have since come out.
While depreciation may seem like a bad thing, it holds advantages as tax write-offs because your business can write off the lost value of the equipment, or asset, and have that count against the profit the business generated over the course of the year.
In regards to equipment depreciation, there are a couple of key terms that you should know:
- Book Value – This is the value of the piece of equipment minus the value that has depreciated. The book value is depreciated until it reaches the salvage value, where it is fully depreciated.
- Depreciable Value – The depreciable value is the amount you purchased the piece of equipment for minus the book value. In other words, this is the amount of value you expect the piece of equipment to lose during the period during which you use it.
- Depreciation Period – The depreciation period is the period of time over which you plan to use the equipment and incrementally subtract the depreciable value from it.
Let’s take a look at a quick example. Let’s say I purchased an excavator for $100,000 and I plan to use it over a period of five years before I sell it and get a new excavator. I have looked at used excavators that are five years old that were purchased for a similar price and they sell for around $60,000. So, I estimate that the salvage value at the end of the five year period during which I plan on using the equipment is $60,000. I plan on using the equipment over a five year period, so the depreciation period is five years, and the depreciable value is $40,000, since I estimate I can sell the excavator for $60,000 and I bought it for $100,000.
So now we know the basics behind depreciation, next let’s look at what you need to know to begin effectively depreciating your equipment.
What SMB Contractors Need to Know About Depreciation
Once you have established an estimated salvage value, depreciable value, and the depreciation period, you have the basic information with which to depreciate the equipment. However, there are a couple of different methods of depreciation that you can use to depreciate your equipment, each method offering a slightly different benefit. Ultimately, you want to consult with an accountant or tax professional to see which method best fits your business, but here are the different types of depreciation methods and their uses:
- Straight-Line Method – This is the simplest and most commonly used method of depreciation and is the one you are probably most familiar with. Straight-line depreciation is just like it sounds; you take the depreciable value, let’s use $40,000 from the earlier example, and you divide that by the number of years you will depreciate the equipment or the depreciation period. So $40,000 divided by five years gives us a depreciable value of $8,000/year. This method is the easiest to perform and gives a nice, steady amount of depreciation over the course of ownership.
- Sum-of-the-Years Method – This method takes into account the number of years you plan to own and depreciate the piece of equipment and applies a variable rate to the total depreciable amount that changes each year, starting at a higher rate and gradually becoming smaller. This is a good method to depreciate a larger proportion of the equipment earlier in its operational lifetime.
- Declining-Balance Method – This depreciation method, similar to the Sum-of-the-Years method, is an accelerated method that determines a constant rate to apply to the remaining depreciable amount and is applied until the equipment is completely depreciated and reaches its salvage value.
Each method has its different uses and applications. Next, we will take a look at how each of the three different methods are calculated.
How to Calculate Equipment Depreciation
This is the most straightforward formula, with the annual depreciation rate (R):
R = 1/N
N is the number of years the equipment is owned.
To expand on the previous example,
R = 1/5 = 0.2
Then, we find our annual depreciable amount (D) with the following formula:
D = R (P – F)
P is the initial purchase value
F is the salvage value after N years
So, the annual depreciable amount is this:
D = 0.2 ($100,000 – $60,000) = $8,000.
This means that we will depreciate $8,000/year over the course of five years to fully depreciate the excavator. The book value each year will be the value after the excavator has been depreciated by $8,000, with the book value further declining as the equipment ages.
The sum of the years uses a formula to apply a variable rate which is weighted heavier at the beginning of ownership with respect to depreciation rate:
R = N – m + 1 / SOY
N is the depreciable period
m is the specific year in which the depreciation is being determined
SOY = Sum of the years, which is calculated by the following formula:
SOY = N (N + 1) / 2
So, let’s take a look at what the depreciable amount would be in the first year of ownership using the Sum-of-the-Years method:
SOY = 5 (5 + 1) / 2 = 15
R = (5 – 1 + 1) / SOY (15) = 5 / 15 or 0.33
So our depreciable amount for the excavator for the first year using this method would be 0.33 x Depreciable Amount ($40,000) = $13,200.
However, let’s look at what happens to the depreciation on the second year:
R = (5 – 2 + 1) / SOY (15) = 4 / 15 or 0.27
0.27 x Depreciable Amount ($40,000) = $10,800.
As you can see, with this method the annual depreciation amount is the highest the first year and gradually begins to taper off as the equipment ages.
This method applies an accelerated rate that can be determined based on how aggressively you want to depreciate the excavator. The formula for this method is as follows:
R = X / N
X is a factor between 1.25 through 2, with 2 being the most aggressive depreciation rate.
The depreciation amount each year is determined by the following formula:
D = (BVm-1) R
D is the annual depreciation amount
BV is the book value
m is the current year which is being depreciated
R is the depreciation rate
Once you have the rate, you multiply the current book value by the declining-balance depreciation rate and depreciate that much of the excavator, until you fully depreciate it. Let’s look at the first year of declining balance using an X factor of 2:
R = 2 / 5 = 0.4
D = $100,000 x 0.4 = $40,000
For the declining-balance method, that’s it! Because we fully depreciated the excavator in the first year, we will not depreciate it any further in subsequent years.
Section 168 Accelerated Depreciation
Note that there is a section of the IRS code which is available for equipment, machinery, buildings, and some others which allows for a bonus depreciation in the early years. It’s normally done with a 200% declining balance followed by a straight line method. Consult your tax professional for more information on Section 168.
Tax and Book Depreciation Differences
Many times a piece of equipment will be carried on a contractor’s accounting books at a different amount with the depreciation included versus what is shown on the contractor’s tax records. These differences could be very large, because they may not be able to show a piece of equipment with accelerated depreciation on their accounting records compared to what happened on a tax basis, or the equipment may be required to be depreciated over a different time frame. Tracking the depreciation differences is important to be able to reconcile book accounting profitability versus tax profitability over time.
Depreciation may seem complicated and a hassle, but trust me, there is a big benefit in correctly depreciating your equipment as you purchase it and keep it on your books as assets. First, you will offset your taxable profit that the business generates by taking into account the artificial expense which you are already incurring as your equipment loses its value with age. Second, correctly depreciating your equipment will help you to have a more accurate picture of your business’s balance sheet, reflecting the accurate value of the equipment that you own and the assets your business controls.
As you begin to grow your business and you are looking to purchase heavy equipment, make sure that you have a good plan in place with your accountant or financial advisor with regards to the depreciation strategy you will end up using.
Further Reading – Essentials of Construction Accounting: A Contractor’s Guide
Want to make your accounting processes a whole lot easier? Sign up for early access to CrewCost. It’s accounting software that’s actually built for construction, by people who have been in the industry for decades.
The CrewCost Team consists of men and women who have worked in the construction industry as project managers, general contractors, sub contractors and more. They share their decades of experience on our blog as a way to help other contractors grow healthier and more profitable businesses.