- Depreciation is the process of deducting the cost of a business asset over a long period of time, rather than over the course of one year.
- There are four main methods of depreciation: straight line, double declining, sum of the years' digits and units of production.
- Each method is used for different types of businesses and types of assets.
Depreciation is often misunderstood as a term for something simply losing value, or as a calculation performed for tax purposes. Depreciation is an important part of your business's tax returns, but it is a complex concept. Keep reading to learn what depreciation is, how it is calculated and how your depreciation calculation can affect your business.
What is depreciation?
Depreciation has two main aspects. The first aspect is the decrease in the value of an asset over time. The second aspect is allocating the price you originally paid for an expensive asset over the period of time you use that asset.
The number of years over which an asset is depreciated is determined by the estimated useful life of the asset, or how long the asset can be used. For example, the estimate useful life of a laptop computer is about five years.
There are multiple classes of assets, including commodities and property. When doing your yearly budget or balance sheet, asset depreciation is considered a fixed cost, unless you are using a method where the depreciable amount changes every year (such as the unit of production method), in which case it would be a variable cost.
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What assets can be depreciated?
The IRS has specific guidelines about what types of assets can be depreciated for accounting purposes. According to the IRS, to be depreciable, an asset must
- Be owned by you
- Be used in your business or to produce income
- Have a determinable useful life
- Be expected to last for more than one year
Some examples of the most common types of depreciable assets include vehicles; buildings; office equipment or furniture; computers and other electronics; machinery and equipment; and certain intangible items, such as patents, copyrights, and computer software.
What assets cannot be depreciated?
You cannot depreciate an asset that does not meet the IRS' requirements, so nothing that does not wear out, become obsolete or get used up. You also cannot depreciate
- Land
- Collectibles (e.g., art, coins, memorabilia, etc.)
- Investments (e.g., stocks and bonds)
- Personal property
- Any asset used for less than one year
Types of depreciation
There are multiple methods of depreciation used in accounting. The four main types of depreciation are as follows.
1. Straight-line depreciation
This is the simplest and most straightforward method of depreciation. It splits an asset's value equally over multiple years, meaning you pay the same amount for every year of the asset's useful life.
Straight-line depreciation is a good option for small businesses with simple accounting systems or businesses where the business owner prepares and files the tax return.
The advantages of straight-line depreciation are that it is easy to use, it renders relatively few errors, and business owners can expense the same amount every accounting period.
However, its simplicity can also be a drawback, because the useful life calculation is largely based on guesswork or estimation. It also does not factor in the accelerated loss of an asset's value in the short term or the likelihood that maintenance costs will go up as the asset gets older.
- Depreciation formula: Divide the cost of the asset (minus its salvage value) by the estimated number of years of its useful life. The "salvage value" is the estimated amount of money the item will be worth at the end of its useful life. Here's what the formula looks like: (Cost of asset - Salvage value of asset) / Useful life of asset = Depreciation expense
[Related Content: What Is EBITDA And How Is It Used?]
2. Double-declining depreciation
This method, also called declining balance depreciation, allows you to write off more of an asset's value right after you purchase it and less as time goes by. This is a good option for businesses that want to recover more of the asset's value upfront rather than waiting a certain number of years, such as small businesses that have a lot of initial costs and are in need of extra cash.
The double-declining balance method is advantageous in that it can help offset increased maintenance costs as an asset gets older; it can also maximize tax deductions by allowing higher depreciation expenses in the early years.
However, if your business has already had a tax loss for a given year, you won't benefit from an additional tax deduction.
- Depreciation formula: 2 x (Single-line depreciation rate) x (Book value at beginning of the year). Or, you can use a double-declining calculator. The "book value" is the asset's cost minus the amount of depreciation you have already taken.
3. Sum of the years' digits depreciation
Sum of the years' digits (SYD) depreciation is similar to the double-declining method in that it is also an accelerated depreciation calculation. Instead of decreasing the book value, SYD calculates a weighted percentage based on the remaining useful life of the asset.
SYD suits businesses that want to recover more value upfront, but with more even distribution than they would otherwise get using the double-declining method. The SYD method's main advantage is that the accelerated depreciation reduces taxable income and taxes owed during the early years of the asset's life. The main drawback of SYD, though, is that it is markedly more complex to calculate than the other methods.
- Depreciation formula: (Remaining lifespan / SYD) x (Asset cost - Salvage value). You must first calculate the SYD by adding together the digits for each depreciation year. For example, the SYD calculation for five years is 5+4+3+2+1=15. You then divide each year by this sum to calculate that year's depreciation percentage. To find the percentage for the first year's depreciation, you would divide the digit of the first year (5) by the SYD total (15), which comes out to 33% (5 / 15 = 33%).
[See: Helpful Accounting Formulas and Ratios]
4. Units of production depreciation
This is a simple way to depreciate the value of an asset based on how frequently the asset is used. "Units of production" can refer to something the equipment makes — like the number of pizzas that can be made in a pizza oven, or the number of hours that it's in use. This method is good for businesses that want to write off equipment with a quantifiable and widely accepted (i.e., based on the manufacturer's specifications) output during its useful life. Make sure you have a method in place for tracking your use of equipment, and expect to write off a different amount every year.
The main advantage of the units of production depreciation method is that it gives you a highly accurate picture of your depreciation cost based on actual numbers, depending on your tracking method. Its main disadvantage, though, is that it is difficult to apply to many real-life situations, as it is not always easy to estimate how many units an asset can produce before it reaches the end of its useful life.
- Depreciation formula: (Asset cost - Salvage value) / Units produced in useful life
How does deprecation affect tax liability?
Depreciation reduces the taxes your business must pay via deductions by tracking the decrease in the value of your assets. Your business's depreciation expense reduces the earnings on which your taxes are based, which, in turn, reduces the taxes your business owes the IRS. The larger the depreciation expense, the lower your taxable income.