When you buy a tangible asset, its value decreases over time. Some decrease more quickly than others. This is something you'll probably come to realize when you try to re-sell the item—in most cases, you won't get the same price you originally paid. This is called depreciation. If you run a business, you can claim the value of depreciation of an asset as a tax deduction. In this article, we outline the basics of depreciation and the best way to calculate this value for tax purposes.
Key Takeaways
- Depreciation refers to how much of an asset's value is left over the course of time.
- Businesses can recover the cost of an eligible asset by writing off the expense over the course of its useful life.
- The straight-line method is the simplest and most commonly used way to calculate depreciation under generally accepted accounting principles.
- Subtract the salvage value from the asset's purchase price, then divide that figure by the projected useful life of the asset.
What Is Depreciation?
Depreciation refers to how much of an asset's value is left over the course of time. This value is the result of the asset being used or because it becomes obsolete. These include—but may not be limited to—vehicles, plants, equipment, machinery, and property. So if you purchase a vehicle, it immediately depreciates or loses value once it leaves the lot. It loses a certain percentage of that remaining value over time because of how it's driven, its condition, and other factors.
Depreciation is a tax-deductible business expense. It offers businesses a way to recover the cost of an eligible asset by writing off the expense over the course of its useful life. A business can expect a big impact on its profits if it doesn't account for the depreciation of its assets.
A business that doesn't account for the depreciation of its assets can expect a big impact on its profits.
To account for a tax deduction, a company has several different options available under generally accepted accounting principles (GAAP) to calculate how much an asset depreciates:
- Declining Balance: In this method, larger depreciation expenses are recorded during the earlier years of an asset’s life while smaller expenses are accounted for in its later years.
- Double-Declining: Using this method means that assets depreciate twice as fast as the traditional declining balance method. It also accounts for larger depreciation expenses during the earlier years of an asset’s life and smaller ones in its later years.
- Sum-of-the-Years’ Digits: To calculate depreciation using this method, the asset's expected life is added together. Each year is then divided by that figure starting with the higher number in the first year.
- Units of Production: Companies benefit from greater deductions when they use this method. That's because the value of an asset is related to the number of units it produces rather than how many years it's used.
- Straight-Line Method: This is the most commonly used method for calculating depreciation. In order to calculate the value, the difference between the asset's cost and the expectedsalvage value is divided by the total number of years a company expects to use it.
The Straight-Line Method
As mentioned above, the straight-line method or straight-line basis is the most commonly used method to calculate depreciation under GAAP. This method is also the simplest way to calculate depreciation. It results in fewer errors, is the most consistent method, and transitions well from company-prepared statements to tax returns.
Depreciation using the straight-line method reflects the consumption of the asset over time and is calculated by subtracting the salvage value from the asset's purchase price. That figure is then divided by the projected useful life of the asset.
Here's an example. Say a catering company purchases a delivery van for $35,000. The expected salvage value is $10,000 and the company expects to use the van for five years. By using the formula for the straight-line method, the annual depreciation is calculated as:
($35,000 - 10,000) ÷ 5 = $5,000.
This means the van depreciates at a rate of $5,000 per year for the next five years.
In the event the asset is purchased on a date other than the beginning of the year, the straight-line method formula is multiplied by the fraction of months remaining in the year of purchase. Using the example above, if the van was purchased on October 1, depreciation is calculated as:
(3 months / 12 months) x {($35,000 - 10,000) / 5} = $1,250.
In the first year, the catering company writes off $1,250.
Advisor Insight
Morris Armstrong, Enrolled Agent
Armstrong Financial Strategies, Cheshire, CT
The "best method" is the one appropriate for your business and situation. That may sound snarky, but I don’t intend it to be. I just mean that sometimes people want to write something off as quickly as possible, even if they do not have the annual income to warrant it. So they accelerate the deduction schedule, only to realize later on that they would have been better off taking the depreciation at a slower, more consistent pace.
That is why, if given the choice, you should run the various depreciation-calculation scenarios through the tax program with an eye not only on the current return but on returns down the road, and the condition of your company in future years as well.
FAQs
The straight-line method is the simplest and most commonly used way to calculate depreciation under generally accepted accounting principles. Subtract the salvage value from the asset's purchase price, then divide that figure by the projected useful life of the asset.
Which depreciation method is best for tax purposes? ›
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.
What is the best method to calculate depreciation? ›
The most common way to calculate depreciation is the straight-line method. The difference between the fixed asset cost and its salvage value is divided by the useful life of that asset in years to get the depreciating value, which is the same for each year of the asset's life.
Which depreciation method is most popular for reporting in the financial statements? ›
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.
Can I use straight-line depreciation for tax purposes? ›
The straight-line depreciation method is a type of tax depreciation that an asset owner can elect to deduct the cost of the asset over the property's useful life evenly.
What are the 2 most popular methods of depreciation? ›
The most common depreciation methods include: Straight-line. Double declining balance.
Which depreciation method is fastest? ›
Double-Declining Balance Method
The double-declining balance (DDB) method is an accelerated depreciation method. After taking the reciprocal of the useful life of the asset and doubling it, this rate is applied to the depreciable base—also known as the book value, for the remainder of the asset's expected life.
What is the method of depreciation in income tax? ›
Depreciation is a mandatory deduction in the profit and loss statements of an entity using depreciable assets and the Act allows deduction either using the Straight-Line method or Written Down Value (WDV) method. The calculation for depreciation under the WDV method is widely used.
Is straight-line depreciation the most 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 used by most US companies for financial reporting purpose? ›
Straight‐line depreciation is the method that companies most frequently use for financial reporting purposes.
Depreciation is a method used to allocate a portion of an asset's cost to periods in which the tangible assets helped generate revenue. A company's depreciation expense reduces the amount of taxable earnings, thus reducing the taxes owed.
Do companies prefer straight-line or accelerated depreciation? ›
The firms prefer to use the accelerated depreciation method over the straight-line method for tax purposes because accelerated depreciation offers an approach of rescheduling corporate income taxes by decreasing current years' taxable income.
Why use straight-line depreciation for financial reporting? ›
Accountants use straight-line depreciation because it is easy to calculate, is less of an administrative burden and is less prone to error.
Is straight-line or accelerated depreciation better? ›
Accelerated depreciation is appropriate for assets that are expected to have a long life and have a high value. Straight-line is an appropriate valuation method for assets that have a shorter life and a lower value.
Which depreciation method results in highest income? ›
Depreciation calculation and amortization valuation under Straight line method determines the highest net income in the first year. Under this method the depreciation amount remains the same through-out the life of a fixed asset and depreciation occurs uniformly.
Which method of depreciation is least used? ›
The four methods for calculating depreciation allowable under GAAP include straight-line, declining balance, sum-of-the-years' digits, and units of production. 2. The best method for a business depends on size and industry, accounting needs, and types of assets purchased.
Which depreciation method records the highest total depreciation? ›
Specifically, the DDB method depreciates assets twice as fast as the traditional declining balance method. The DDB method records larger depreciation expenses during the earlier years of an asset's useful life, and smaller ones in later years.
When should straight-line depreciation be used? ›
When Should One Use Straight Line Deprecation? Straight line is the most straightforward and easiest method for calculating depreciation. It is most useful when an asset's value decreases steadily over time at around the same rate.
Which method almost always produces the most depreciation? ›
Explanation: The double-declining balance method almost always produces the highest depreciation...
Why is straight-line method better? ›
Accountants prefer the straight line basis because it is easy to calculate and understand. The method allocates an even amount to each accounting period over the asset's useful life making it a predictable expense, and allows for the smoothing of net income.
There is a number of different methods accountants can use to calculate depreciation of Fixed Assets in Balance Sheet. Among them, there are two main methods of calculating depreciation that are widely used by accountants around the world: Straight-Line Method. Reducing Balance Method.
What are the two methods of depreciation used for financial statement reporting? ›
Depreciation can be calculated using the straight-line method or the accelerated method. The salvage value and the expected useful life are two assumptions made when calculating depreciation that can alter the financial results of a company.
Which depreciation method depreciates an asset more quickly? ›
Accelerated Depreciation is an accounting method that allows the owner of an asset to depreciate the asset more quickly by using a shorter period of depreciation than the traditional straight-line method.
What is one advantage of using straight line method of depreciation? ›
The following are the advantages of the straight line method of calculating depreciation: It is simple to understand and apply. The asset value can be completely written off using this method. Asset value can be made zero value at the end of useful life.
How does a business decide which depreciation method is best to use? ›
The businesses choose the depreciation method that is best suited for their business by evaluating the aspects such as the type of business the company is doing, the types of assets purchased, duration of the use of assets (estimated useful life), number of shifts or time interval in which the asset is used.
Why do companies use different depreciation methods for tax reporting and financial reporting? ›
Companies use different methods for tax reporting and financial reporting because by using the straight-line method in financial reporting a company is able to spread costs evenly over the useful life of an asset, reducing the revenue and asset values uniformly.
Which depreciation method is not acceptable for financial reporting under GAAP? ›
Use of Double-Declining-Balance on Financial Statements
Generally, companies will not use the double-declining-balance method of depreciation on their financial statements.
What is the difference between tax depreciation and book depreciation? ›
The phrase "tax depreciation" is used to refer to the amount of depreciation that a taxpayer claims as a deduction on their tax return for a certain tax year. Book depreciation is the expense recorded by a company for the use of a fixed asset over the useful life of that asset.
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 depreciation method provides the fastest write off of an asset? ›
By using accelerated depreciation, an asset with a tax basis may now be written off more quickly.
