What Is Depreciation? Definition, Types, How to Calculate
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Depreciation is an accounting method that spreads the cost of an asset over its expected useful life. Businesses record depreciation as a periodic expense on the income statement. Assets lose value as they depreciate over time. There are four main methods used to calculate depreciation: straight-line, units of production, double declining balance and sum of the years' digits.
Types of depreciation
Businesses have some control over how they depreciate their assets over time. Good small-business accounting software will help you calculate, record and track depreciation, but you'll still need to understand the process in order to make important decisions about how your business will record depreciation. Here are four common methods of calculating depreciation, along with when it's best to use them.
1. Straight-line depreciation
This is the most common and simplest depreciation method.
Formula: (Cost of asset – Scrap value of asset) / Useful life of asset = Depreciation expense
Most often used for: Equipment that loses value steadily over time.
Pros: It spreads the expense evenly over each accounting period. It’s also easy to automate the adjusting entry for straight-line depreciation in most accounting software.
Cons: Determining the useful life of the asset requires guesswork. A miscalculation could result in the asset being overvalued for several years.
2. Units of production depreciation
Units of production depreciation is based on how many items a piece of equipment can produce.
Formula: (Number of units produced / Life of asset in units) x (Cost of asset – Scrap value of asset) = Depreciation expense
Most often used for: Manufacturing for equipment that is expected to produce a certain number of items before it's no longer useful.
Pros: Easy to calculate. Because it’s tied to the number of items a piece of equipment produces, it creates a more accurate depreciation calculation.
Cons: You have to keep an accurate record of how many items the equipment has produced. Because production will likely vary from month to month, you’ll need to manually enter this depreciation expense into your accounting software every month. The entry can’t be automated, as it can with straight-line depreciation.
3. Double declining balance depreciation
Double declining balance depreciation is an accelerated depreciation method. Businesses use accelerated methods when dealing with assets that are more productive in their early years. The double declining balance method is often used for equipment when the units of production method is not used.
Formula: (100% / Life of asset = Depreciation rate) x 2
Most often used for: Vehicles and other assets that lose value quickly. It writes off an asset’s value the quickest.
Pros: Represents the loss of certain assets’ value more accurately than straight-line depreciation.
Cons: The calculations are more complex than the other methods. Usually business owners using accelerated methods will set up a depreciation schedule — a table that shows the depreciation expense for each year of the asset’s life — so they only have to do the calculations once.
4. Sum of the years’ digits depreciation
Sum of the years’ digits depreciation is also an accelerated depreciation method. It doesn’t depreciate an asset quite as quickly as double declining balance depreciation, but it does it quicker than straight-line depreciation.
Formula: (Remaining life of the asset / Sum of the years' digits) x (Cost of asset – Scrap value of asset) = Depreciation expense
Most often used for: Assets that could become obsolete quickly.
Pros: Lets you choose how many years you want to depreciate an asset, based on its useful life. This gives you control over the depreciation expense you record each month.
Cons: The most difficult depreciation method to calculate. If you use it with the wrong type of asset, you can easily overstate or understate your net income in a given accounting period.
Let’s say you purchase a piece of equipment for $260,000. You anticipate using the equipment for eight years, and you anticipate the scrap value will be $20,000. The annual and monthly depreciation expenses for the vehicle using the straight-line depreciation method would be:
($260,000 – $20,000) / 8 = $30,000
$30,000 / 12 months = $2,500 per month
Find out what your annual and monthly depreciation expenses should be using the simplest straight-line method, as well as the three other methods, in the calculator below.
Understanding depreciation in business and accounting
Depreciation is an expense, which means that it appears as a line item on your income statement and reduces net income. Many small-business owners find depreciation confusing because the depreciation expense on the income statement doesn't match cash flow. Remembering the following points can help simplify the concept.
Depreciation is not a cash expense. That is, a business does not write a check to "depreciation." Instead, the business records or recognizes the cost of the asset over time on the income statement.
Accordingly, depreciation usually doesn’t coincide with when the business buys the asset, even if the purchase is made over time with installment payments.
Depreciation matches expenses to a given time period, but it isn’t strictly an accrual-basis concept. This calculation will appear on both cash basis and accrual-basis financial statements.
Using depreciation to manage cash requirements
One often-overlooked benefit of properly recognizing depreciation in your financial statements is that the calculation can help you plan for and manage your business’s cash requirements. This is especially helpful if you want to pay cash for future assets rather than take out a loan to acquire them.
Because you've taken the time to determine the useful life of your equipment for depreciation purposes, you can make an educated assumption about when the business will need to purchase new equipment. The earlier you can start planning for that purchase — perhaps by setting aside cash each month in a business savings account — the easier it will be to replace the equipment when the time comes.
Depreciation and taxes
The four methods described above are for managerial and business valuation purposes. Tax depreciation is different from depreciation for managerial purposes.
Tax depreciation follows a system called MACRS, which stands for modified accelerated cost recovery system. MACRS is a form of accelerated depreciation, and the IRS publishes tables for each type of property. Work with your accountant to be sure you’re recording the correct depreciation for your tax return.