When you spend a lot of money on a piece of heavy equipment like an excavator, you expect it to help you make more money. As the years go by though, that excavator is no longer the newest model. Now there are better models with advancements that could help you work easier and faster. Construction equipment, like any other asset, loses value with age, and this loss in value is called depreciation.
While it may seem like a bad thing, there’s a lot more to equipment depreciation 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. For construction 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. So how can you put this all into practice? Here’s how to manage your equipment duration in construction.
Key Takeaways
- Depreciation is the gradual loss of value of a piece of equipment over time. For tax purposes, it allows construction companies to deduct the declining value as an expense to lower taxable income.
- There are several different methods of calculating depreciation, including straight-line, sum-of-the-years, and the declining balance method.
- Tracking depreciation accurately describes the real value of the equipment assets on a business’s balance sheet over time. This helps with accounting and can make it easier for contractors to decide when to replace aging equipment.
What is Equipment Depreciation?
In the construction industry, equipment depreciation is simply a way of looking at an asset purchased for a fixed price and recognizing that it won’t be worth the same amount of money over the course of its lifespan. Assets depreciate for several reasons, including wear and tear, or because newer models of equipment come out.
While it may seem like a bad thing, depreciation actually has some advantages. For example, construction businesses can write off the lost value of the asset during tax season, and have that lost value count against the profit the business generated over the year.
When it comes to equipment depreciation, here a couple of terms to get familiar with:
- Book Value – 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 equipment’s purchase price 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 that five year period is $60,000. I plan on using the equipment over a five year period, so the depreciation period is five years, which means the depreciable value is $40,000, since I estimate I can sell the excavator for $60,000 and the cost of the equipment was $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’ve established an estimated salvage value, depreciable value, and the depreciation period, you have the basic information you need to depreciate the equipment.
There are a few different methods of depreciation you can use to depreciate your equipment, with 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.
- 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 (aka its estimated useful life). So $40,000 divided by five years gives us a depreciation value of $8,000/year. This is the easiest method to use and gives a nice, steady rate of depreciation over the useful life of the asset.
- Sum-of-the-Years Method – This method takes into account the number of years you plan to own and depreciate the piece of equipment. Sum-of-the-Years 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.
Now let’s go over some examples of depreciation calculation using these three methods.
How to Calculate Equipment Depreciation
Let's walk through how to use each depreciation method.
Straight-Line Method
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 cost of the asset
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.
Sum-of-the-Years Method
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
With this method, the annual depreciation amount is the highest the first year and gradually begins to taper off as the equipment ages.
Declining-Balance Method
This method applies an accelerated rate that’s determined based on how aggressively you want to depreciate the excavator. Here’s the formula:
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 your 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 won’t depreciate it any further in subsequent years.
Section 168 Accelerated Depreciation
🚧 Heads up: There’s a section of the IRS code available for equipment, machinery, buildings, and some others that 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
Oftentimes a piece of equipment will be carried on a contractor’s accounting books at a different amount, with the depreciation included vs. what’s shown on the contractor’s tax records.
These differences could be pretty significant, 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. Carefully tracking these makes it easier to reconcile book accounting profitability versus tax profitability over time.
Wrapping Up
Depreciation may seem like a hassle, but trust me, there’s a big benefit in correctly depreciating your equipment. First, you’ll offset your taxable profit 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 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 grow your business and start to purchase more heavy equipment, make sure you have a good plan in place with your accountant or financial advisor when it comes to your depreciation strategy.
Further Reading – The Ultimate Guide to Construction Accounting for Contractors
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