Depreciation of assets is an integral part of a company’s tax strategy which lowers the amount of earnings taxes are based on. This in turn reduces the amount of taxes owed. Generally Accepted Accounting Principles (GAAP) give business owners the choice of 5 different methods of depreciation to use: Each method calculates the rate of depreciation differently and some are better fits for different types of companies. Some businesses choose one method for depreciating all their assets while some use two or more methods. The reason for using different methods could depend on the useful life of the asset or the company wanting larger deductions early. RELATED CONTENT: EGUIDE UNDERSTANDING THE TYPES OF DEPRECIATION BUSINESSES CAN UTILIZE Before we look at each method more closely, let’s review the terms used in the formulas and what they mean. Original Cost of the Asset This is the initial cost that was paid for the asset. Salvage Value The estimated salvage price a business believes it would be able to get for the asset by selling it at the end of its useful life. Useful Life of the Asset The expected amount of time the asset will be of use to the company. Current Book Value The net value of an asset at the beginning of an accounting period. This is calculated by taking the cost of the asset and subtracting the accumulated depreciation. Depreciation Rate The rate (as a percentage) at which an asset is depreciated over its estimated lifespan. (Formula = 1/Useful Life of the Asset) Remaining Lifespan An estimate (in years) of an asset’s usefulness. SYD (Sum of the Years' Digits) The sum of the digits of an asset’s expected life. For example, if an asset is expected to last for 4 years, the SYD would be 10 (4 + 3 + 2 + 1 = 10). Estimated Units Over Asset’s Lifetime Number of units an asset is expected to produce during its lifetime. Actual Units Made Number of units the asset produced during the current year. This is the simplest and most used depreciation method. It is best for smaller businesses that are looking for a simple way to calculate depreciation. With the straight-line method, you are calculating a depreciation amount that is the same year after year for the life of the asset. This is what makes it the simplest method to use. Example: A company purchases a machine for $10,000 that has a useful life of 5 years and a salvage value of $2,000 at the end of its useful life. The company will use the straight-line depreciation method to depreciate the asset over its useful life. To calculate the depreciation expense for each year, the company will use the following formula: (Original Cost of the Asset - Salvage Value) / Estimated Useful Life of the Asset In this case, the cost of the asset is $10,000, the salvage value is $2,000, and the useful life is 5 years. Plugging these values into the formula, we get: Depreciation expense = ($10,000 - $2,000) / 5 Depreciation expense = $1,600 per year The company will record a depreciation expense of $1,600 per year for the next 5 years. At the end of the useful life, the book value of the asset will be equal to the salvage value of $2,000. This method is best suited for companies that have assets that lose value faster in the early years. Technology (such as computers and cell phones) is an example of an asset that becomes obsolete quickly. The declining balance method provides larger deductions sooner, minimizing tax exposure. It is considered a type of accelerated depreciation. Example: A company purchased a machine for $10,000, and they have decided to depreciate it using the declining balance method. The company has estimated that the machine will have a useful life of five years and a salvage value of $1,000. To calculate the annual depreciation expense, we will use the following formula: Current Book Value x Depreciation Rate The depreciation rate is calculated by dividing the straight-line rate by the chosen factor. In this case, the company has decided to use a factor of 2, meaning that the depreciation rate will be twice the straight-line rate. Straight-line rate = 1 / Useful Life = 1 / 5 = 0.2 or 20% Depreciation rate = 2 x Straight-line rate = 2 x 0.2 = 0.4 or 40% Year 1: Year 2: Year 3: Year 4: Year 5: At the end of the five-year period, the machine will have a book value of $777.60, which is its salvage value. Also known as the reducing balance method, double declining is another accelerated depreciation method that, as the name implies, depreciates assets twice as fast as the declining balance method. It is another method that is commonly used by businesses. As with the declining balance method, double declining is best suited for assets that tend to lose much of their value at the beginning of their useful life. Assets that may become obsolete quickly are another good fit for this method. Example: a company has a piece of machinery that costs $10,000 and has a useful life of 5 years. They decide to use the double-declining balance method to depreciate the asset. The formula for double-declining balance depreciation is: 2 x Depreciation Rate x Current Book Value So, the book value at the end of the first year will be: Book value at the end of year 1 = $10,000 - $4,000 = $6,000 In the second year, the book value is $6,000. Using the formula, the depreciation expense for the second year is: Depreciation expense = (2 / 5) x $6,000 = $2,400 So, the book value at the end of the second year will be: Book value at the end of year 2 = $6,000 - $2,400 = $3,600 And so on, until the end of the asset's useful life. This method results in higher depreciation expenses in the earlier years, reflecting the idea that assets are typically more productive and efficient when they are newer. Another accelerated depreciation method, SYD results in larger depreciation amounts early in the life of an asset, but not as aggressively as declining balance. This method is geared towards assets that lose value quickly or produce at a higher capacity during the early years. Example: A company purchased a delivery truck for $50,000 with an estimated useful life of 5 years and no salvage value. The company decides to use the sum-of-the-years digits method to depreciate the asset. To calculate the depreciation expense for each year, we first need to calculate the sum-of-the-years digits (SYD) for the truck: (Remaining Lifespan / SYD) x (Original Cost of the Asset - Salvage Value) SYD = (n * (n+1))/2 where n is the useful life of the asset. Year 1: Depreciation expense = (5/15) * $50,000 = $16,667 Year 2: Depreciation expense = (4/15) * $50,000 = $13,333 Year 3: Depreciation expense = (3/15) * $50,000 = $10,000 Year 4: Depreciation expense = (2/15) * $50,000 = $6,667 Year 5: Depreciation expense = (1/15) * $50,000 = $3,333 At the end of 5 years, the accumulated depreciation will equal the original cost of the truck, and the book value will be zero. This depreciation method does not use time as a factor in calculating depreciation. It uses the number of units an asset actually produces and the estimate of how much it will produce over its lifetime. Companies that produce or manufacture goods would find this method useful. Example: A company purchased a machine for $100,000 that is expected to have a total production capacity of 500,000 units. In the first year, the machine produced 50,000 units. Depreciation Per Unit = (Cost of Asset - Salvage Value) / Estimated Units Produced Over Asset's Lifetime Units-of-production depreciation = Depreciation Per Unit x Actual Units Produced Depreciation Per Unit = ($100,000 - $10,000) / 500,000 Depreciation Per Unit = $90,000 / 500,000 Depreciation Per Unit = $0.18 Units of Production Depreciation = $0.18 x 50,000 Units of Production Depreciation = $9,000 Therefore, the depreciation expense for the first year will be $9,000. The remaining book value of the machine at the end of the first year will be $100,000 - $9,000 = $91,000. There are some assets that business owners cannot depreciate. Here are a few examples: Land Even though land is considered a fixed asset, it is never depreciated since its useful life is unlimited. Buildings and some land improvements may qualify for depreciation, but not the land itself. Accounts Receivable/Inventory These assets are not depreciable as it is assumed they will turn into cash in a short amount of time, usually within 1 year. Minimal Useful Life/Low-Cost Assets Assets that have little useful life and/or are low-cost are considered expenses, so not depreciable. The Tax Cuts and Jobs Act (TCJA) raised the bonus depreciation deduction from 50% to 100%. It allows companies to deduct a large portion of the purchase price of the asset during the first year it is in service, instead of spreading the deductions out over the asset’s useful life like the methods above. If a company decides to take bonus depreciation, it must be during the first year of the asset’s life, or they can choose to use one of the depreciation methods above. This percentage applies to assets acquired between 9/27/2017 and 1/1/2023. Here are the planned rates for upcoming years: (These rates may change if Congress changes the law.) RELATED CONTENT: Biz Tip Manufacturers: Take Advantage of 100% First-Year Bonus Depreciation Deciding which depreciation method to use will depend on what your assets are used for and how you want to apply depreciation: slow and steady, start quickly, or based on units of production. If you’re not sure which method is the best fit for your assets, get advice from an accounting professional. They will walk you through the differences and suggest which method(s) you should choose.Methods of Depreciation
Straight Line Method
Straight Line Depreciation Formula:
Declining Balance Method
Declining Balance Depreciation Formula:
Beginning book value = $10,000
Depreciation Expense = $10,000 x 0.4 = $4,000
Ending book value = $10,000 - $4,000 = $6,000
Beginning book value = $6,000
Depreciation Expense = $6,000 x 0.4 = $2,400
Ending book value = $6,000 - $2,400 = $3,600
Beginning book value = $3,600
Depreciation Expense = $3,600 x 0.4 = $1,440
Ending book value = $3,600 - $1,440 = $2,160
Beginning book value = $2,160
Depreciation Expense = $2,160 x 0.4 = $864
Ending book value = $2,160 - $864 = $1,296
Beginning book value = $1,296
Depreciation Expense = $1,296 x 0.4 = $518.40
Ending book value = $1,296 - $518.40 = $777.60Double Declining Balance Method
Double Declining Balance Depreciation Formula:
Sum of the Years' Digits (SYD) Depreciation
Sum of the Years Digits Depreciation Formula:
Units of Production Method
Units of Production Depreciation Formula:
What Assets Cannot Be Depreciated?
Don't Forget About Bonus Depreciation!
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FAQs
5 Depreciation Methods Business Owners Need to Know | SVA? ›
And the following methods; straight-line method, written down value method, production unit method, annuity method, sinking fund method have their features making the depreciation process unique.
What are the 5 depreciation methods? ›And the following methods; straight-line method, written down value method, production unit method, annuity method, sinking fund method have their features making the depreciation process unique.
How do I know which depreciation method to use? ›- Straight line depreciation spreads the cost evenly over a number of years.
- Accelerated depreciation writes off a greater portion of the cost in early years and a smaller portion in later years.
- Units of production depreciation writes off an asset as it is actually used.
Straight-line depreciation is the most frequently used method, and it involves spreading the cost of an asset evenly over its useful life. This results in a consistent amount of depreciation expense each year.
How do you calculate 5 depreciation? ›Subtract the asset's salvage value from its cost to determine the amount that can be depreciated. Divide this amount by the number of years in the asset's useful lifespan. Divide by 12 to tell you the monthly depreciation for the asset.
What is the most common depreciation method? ›Straight-line method: This is the most commonly used method for calculating depreciation. To calculate the value, the difference between the asset's cost and the expected salvage value is divided by the total number of years a company expects to use it.
What are the main types of depreciation? ›There are four main depreciation methods: straight-line, units of production, double declining balance and sum of the years' digits. If you're not sure which depreciation method to use for each of your assets, your accountant can be a great resource.
What is the simplest depreciation method? ›Straight-line depreciation is the simplest method for calculating depreciation over time. Under this method, the same amount of depreciation is deducted from the value of an asset for every year of its useful life.
Which method of depreciation is more accurate? ›The straight-line method of depreciation is the best method used to account for depreciation as it is easy to calculate and the most commonly used method.
What is the most aggressive method of depreciation? ›- Double declining balance method: Double declining balance = 2 x Straight-line depreciation rate x Book value at the beginning of the year.
- Sum of the years' digits method: Applicable percentage (%) = Number of years of estimated life remaining at the beginning of the year / SYD.
Can a company use multiple depreciation methods? ›
In addition, certain entities may use more than one method of depreciation, such as applying unit depreciation to fixed assets with large unit costs while the group method is applied to other types of assets with lower unit costs.
How is depreciation used in business? ›Depreciation is the process of deducting the total cost of something expensive you bought for your business. But instead of doing it all in one tax year, you write off parts of it over time. When you depreciate assets, you can plan how much money is written off each year, giving you more control over your finances.
Which method of depreciation is better and why? ›Straight Line Method
This is the simplest and most used depreciation method. It is best for smaller businesses that are looking for a simple way to calculate depreciation. With the straight-line method, you are calculating a depreciation amount that is the same year after year for the life of the asset.
Let's say you need to determine the depreciation of a delivery truck. The truck costs $30,000. It has a salvage value of $3,000, a depreciable base of $27,000, and a five-year useful life. To find the annual depreciation expense, divide the truck's depreciable base by its useful life to get $5,400 per year.
What are the 10 methods of depreciation? ›- Straight-line method or fixed installment method or Original cost method.
- Written down value method or Diminishing balance method or Reducing balance method.
- Sum of years digits method.
- Machine hour rate method.
- Depletion method.
- Annuity method.
- Revaluation method.
- Sinking fund method.
When it comes to a business' personal property assessments, there are 3 forms of depreciation: physical, functional obsolescence, and economic obsolescence.
What are the depreciation methods as per IRS? ›- It must be an asset that the business owns.
- It must be used in a business or income-producing activity.
- The asset must have a determinable useful life.
- The asset must be expected to last more than one year.
Examples of Depreciating Assets
Vehicles. Office buildings. Buildings you rent out for income (both residential and commercial property)