If you own physical assets like cars, computers, washing machines, dishwashers, etc, you will gain a great deal if you learn how to calculate depreciation . This isn’t just a concept for your accountant to nail down. It is a very important tool if you want to have financial security. Fortunately, it’s not all that complicated.
What is depreciation?
Depreciation is simply recognizing that physical assets wear out over time. I am not talking about financial tax planning and the IRS rules regarding depreciation. I’m talking about the reality of it.
If you own a home, think about your roof. Sooner or later you’re going to have replace it. If the roof costs $10,000 and you can expect it to last for 20 years, your roof drops $500 in value every single year. That loss in value is the depreciation. And that means your roof costs you $500 a year.
Why is depreciation so important?
Because people forget about it. Did you look up at your roof on January 1st and calculate the depreciation over the last 12 months? Probably not. Very few people think about their assets this way. And that’s why they are thrown for a loss when the asset has to be replaced one day and they have to come up with $10,000 they don’t have.
This leads to stress and worse. It often results in you having to scramble to find the money to replace an asset immediately. That means you might end up paying higher interest rates on borrowed funds. Not a good tone if you ask me.
This is a great financial error that most people I know make – they forget to make allowances for depreciation.
How can you solve this problem?
You can take two steps to insure that depreciation doesn’t throw you for a loop. First, list your major assets on a spreadsheet like this:
As you can see, all you have to do is figure out what it will cost to replace the asset (column B) and by when (column C). Of course you can’t be exact because you don’t know what the “thingy” is going to cost and you don’t when the “thingy” will wear out. But do a bit of research on the internet and take your best guess. This is far better than doing nothing.
Next, divide the replacement cost by the number of years until you have to replace it. That is your annual depreciation cost (column E). To work out your monthly depreciation cost, simply add up the total like I did in column F.
At this point, you know what your depreciation expense is for all your “stuff”. That’s better than 99% of the people out there so congratulate yourself with a double scoop of chocolate ice cream – my favorite. But let’s not stop there.
Your last step is to set up an automatic savings deposit for this amount. I suggest you set up a separate savings account using a company like Perkstreet which is an online bank. They can help you set up your online account with automatic deposits. It won’t cost you anything and they have no minimum account balances. Nice.
Every time one of the listed assets needs to be replaced, use this fund to defray the cost. If you are fortunate, you’ll have enough saved up for each asset. Even if you don’t have all the money you need to replace the asset, you will certainly be better off than if you hadn’t set up this sinking fund.
Depreciation is an expense you incur every single day. Most people don’t recognize it until it hits them in the face and that usually ends up costing them more money and heartache. Don’t let that happen to you.
How do you deal with depreciation? Have you set up a fund for this? How is it working so far?
Ronald R. Dodge, Jr. says
I have maintained depreciations on all of my assets. There is one aspect I do differ from Frank’s approach. When it comes to the house, I do not itemize each little thing at first. The only time when itemization comes into place is when each major area is replaced. For example, my home was valued at $121,000, but for simplicity purposes, we will just say $120,000. We also know homes tend to last a long time, though with repairs along the way. The longest allowed for is 40 years, so I use that number. This means the annual depreciation using the straight line method is 3,000.
As for most assets, I do use the straight line method, but for certain assets like vehicles, I will instead use accelerated depreciation method. There is some judgment call as to at what rate do I use for the acceleration, but it’s also done to reflect there are greater repair costs further down the road for such assets prior to their disposals.
When I look at my annual total depreciation expense, it works out to be about $6,000. Prior to getting laid off, income was in the $50,000’s but then dwindled on down to about $43,000. Now, the household has an annual income of less than $30,000 with raising 5 girls. Not only that, but when I determine the household’s networth, this depreciation factor is always considered as an expense, thus reduces the net income earned for the given year, and that inturn also reduces networth. I do use the accrual basis of networth as a gage of how the family is doing financially. That is what you are essentially doing when you take depreciation into account, but then to be truly accrual basis, you need to follow this same concept with other things like unpaid interest on debts and investments, the portion of prepaid assets that hasn’t been used up yet (rather it be units of usage based like certain tangible assets or time based like term insurance coverage on vehicles). Look at many of the things you pay for in advance (Take a close look at your service dates you are paying for when you pay your bill by the due date) and thus you have that time to use such assets: memberships, insurance, renting, phone service, internet service, etc… About the only services you don’t pay in advance for are water, electricity and gas. That’s because you pay based on units used, which they haven’t been able to reliably bill you in advance for these items given the various variables that’s involved, which makes these numbers not nearly as predictible. I think though, that’s one reason why Cincinnati Water Works has claimed they have the lowest usage rate, but what they don’t tell you, they have a very high fixed cost that works out to be about $163.00 for every 3 months with just a regular residential single family home.
From my self study of retirement, I ended up developing the following rules:
25% of “Actual Gross Earned Income” must go to countable savings, though most preferred to retirement funding, but if not possible due to other circumstances, then still, it must still be going to some combination between retirment funding, net contributions into emergency fund, and net debt reduction.
Needless to say, 2011 and 2012 were bad years for my household income wise. I just graduated from University of Cincinnati with a major in Accounting and a minor in Information System, which now qualifies me for the CPA given I have earned more than 150 semester hours worth (224.3 in actuality if you include the 62 semester hours worth from Cincinnati Metropolitan College which those credit hours are vaporized by the school going belly up and the state board having no record of my transcript from the school, so those hours can’t even be applied to my CPA eligibility requirement).
I am now hopeful to be getting employment now I have this degree and I am working towards my CPA license, which I am going through the self-study books to prepare for the 4 exams.
Anyhow, given those savings rules with the restricted income, I could not get the emergency fund in general to go up much as I was so focused on bringing debt down. Excluding the last 16 months, I have managed to bring debt down by about $5,000 annually while taking retirement funds up by about 8,000 a year, that was until October 2009, when I saw the writing on the wall prior to the lay off that took place in May 2011. October of 2009, when I saw that writing on the wall (Seeing a bare production floor during what suppose to be our busiest month of the year), I shifted gears and instead of me focusing on dropping debt, I really focused on taking my emergency fund up, which I managed to get it up to about $14,000 prior to the lay off. Currently, I have $11,000 in there, so not too bad. The only bad thing though, I had to take out student loans to get me through college, and for financial reasons, I had to earn 2 years worth of college credits within 15 months else it would have been very tough financially for me to complete the BBA in Accounting degree. I graduated with a GPA of 3.88 for having done 90.5 quarter credit hours within the 15 months. The reason for the odd number is because the university switched from quarters to semesters in August 2012. I earned 68 quarter credit hours within the first 11 months, then I earned the remaining 22.5 quarter credit hours (15 semester hours actually) in the fall semester to get my degree. I figured this cost was going to run me up to about $20,000 and it was about $17,000 for me to complete the degree, but I figured it should be well worth it given how far I had already gotten, and this time, I had no realistic choice, but to do it as my job is to be either working or improving myself.
I may have to go a few years yet without really being able to get back onto the savings track, but at least I will be able to stop the bleeding. Now I’m focused on the 4 exams to pass and get that CPA license. Again, I have to do that ASAP just as I had to get my BBA ASAP.
Thank you! DH and I have avoided trying to calculate depreciations b/c we thought it was a lot more complicated. I will bookmark this post and revisit it in a month or so. 🙂
Neal Frankle says
Awesome! You made my day Emily. I love it when readers like you take action. Very cool. Happy Holidays!