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Depreciation is an accounting method used to spread the cost of an asset across its expected useful life. The idea is to record the expense in the periods for which the asset generates revenue. Depreciation reduces asset values over time. There are several ways to calculate depreciation.
Many small-business owners find depreciation confusing because the depreciation expense does not match cash flow. Depreciation usually doesn’t coincide with when the purchase is made, 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.
Types of depreciation
Here are four common methods of calculating depreciation, along with examples of the calculations and when you would use them.
1. Straight-line depreciation
The most common and simplest depreciation method is straight-line depreciation. You subtract the estimated salvage or scrap value of the asset at the end of its useful life from the cost of the asset, then divide that value by the useful life of the asset.
Formula: (Cost of asset – Scrap value of asset) / Useful life of asset = Depreciation expense
Most often used for: Straight-line depreciation is often used for equipment that loses value steadily over time.
Pros: Straight-line depreciation is the easiest form of depreciation to calculate. It splits up the depreciation expense evenly over each accounting period. Unlike other depreciation methods, straight-line depreciation has fewer calculation errors. It’s also easy to automate the adjusting entry for straight-line depreciation in most accounting software.
Cons: In straight-line depreciation, determining the useful life of the asset requires guesswork. A miscalculation in the useful life could result in the asset being overvalued for several years.
Example: 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 depreciation expense for the vehicle using the straight-line method would be:
($260,000 – $20,000) / 8 = $30,000
In order to not skew your end-of-year financial statements, you want to make the depreciation entry each month:
$30,000 / 12 months = $2,500 per month
Each month of the year, you would make the following journal entry:
Debit: Depreciation expense $2,500
Credit: Accumulated depreciation: Equipment $2,500
This will reduce your net income by $2,500 each month, and it will also reduce the value of the asset on your balance sheet by $2,500 each month.
Note that you're not crediting the actual asset account on the balance sheet, but a separate account called accumulated depreciation. The accumulated depreciation account will have a negative balance, which offsets the value of the asset without changing it on the balance sheet. You will often see these accounts as subaccounts of the fixed asset accounts on the balance sheet.
2. Units of production depreciation
Like straight-line depreciation, the units of production depreciation method is also simple to calculate. Instead of being based on time, units of production depreciation is based on the quantity of an item 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: Units of production depreciation is most often used in manufacturing for equipment that is expected to produce a certain number of items before it's no longer useful.
Pros: Units of production depreciation is 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: In order for your units of production depreciation calculation to be correct, you have to keep an accurate record of how many items each piece of 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.
Example: Let’s say you purchased a machine to manufacture whatsits. The machine is expected to produce 120,000 whatsits before it's no longer useful. You pay $260,000 for the machine, and the scrap value is estimated to be $20,000.
Each year, you will determine how many units the machine produces. Let’s assume in year one the machine produces 2,000 whatsits, in year two it produces 4,000 and in year three it produces 8,000:
Year one: (2,000 / 120,000) x ($260,000 – $20,000) = $4,000
Year two: (4,000 / 120,000) x ($260,000 – $20,000) = $8,000
Year three: (8,000 / 120,000) x ($260,000 – $20,000) = $16,000
You will do this calculation yearly until the machine reaches its production capacity of 120,000 whatsits.
As with the straight-line method, divide the depreciation expense by 12 and record the result each month so you don’t skew your financials in the last month of the fiscal year.
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: Double declining balance depreciation is most often used for vehicles and other assets that lose value quickly. It’s usually the form of depreciation that writes off an asset’s value the quickest.
Pros: Double declining balance depreciation represents the loss of certain assets’ value more accurately than straight-line depreciation.
Cons: The calculations for accelerated methods are a bit 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.
Example: Let’s say you don’t know how many units your whatsit manufacturing machine can produce, but you know it’s likely to last eight years. First, you'll need to calculate the rate of depreciation:
100% / Life of asset = Depreciation rate
100% / 8 = 12.5%
You'll multiply the depreciation rate above by two because you are doubling the rate of depreciation:
12.5% x 2 = 25%
Once you have your depreciation rate, you will multiply that rate by the beginning value of the asset to get the depreciation expense for the first year:
Beginning value of asset x Depreciation rate = Depreciation expense
$260,000 x 25% = $65,000
Finally, you need to calculate the value of the asset at the end of year one:
$260,000 (beginning value of asset) – $65,000 (depreciation expense) = $195,000
The depreciation calculation for year two follows the same formula, except now your beginning asset value is $195,000:
$195,000 x 25% = $48,750
And the ending value for year two is calculated:
$195,000 – $48,750 = $146,250
You will continue with these calculations until you reach the scrap value of the asset.
4. Sum of the years’ digits depreciation
Like double declining balance depreciation, sum of the years’ digits depreciation is an accelerated depreciation method. It doesn’t write off an asset quite as quickly as double declining balance depreciation, but it does write it off 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
*The second part of this equation is the depreciation base
Most often used for: Sum of the years’ digits depreciation is often used for assets that could become obsolete quickly due to technological advances.
Pros: Sum of the years’ digits depreciation 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 will recognize each month.
Cons: Sum of the years’ digits depreciation is 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.
Example: Let’s stick with our whatsit machine for this example. First, let’s calculate our depreciation base:
Cost of asset – Scrap value of asset = Depreciation base
$260,000 – $20,000 = $240,000
Next, you'll need to determine the Remaining life of the asset / Sum of the years’ digits piece of the calculation. The remaining life is just as it sounds: It’s the remaining life of the asset. For this example, the remaining life will be eight years in year one, seven years in year two, and so on. The tricky bit of this equation is the sum of the years’ digits piece.
Here’s how the calculation would look in year one:
8 (remaining life) / (8+7+6+5+4+3+2+1) (sum of the years’ digits) = 0.222
And now you multiply this factor by the depreciation base:
0.222 x $240,000 = $53,280
Our year one depreciation expense is $53,280. In year two, our calculation would look like this:
7 (remaining life) / (8+7+6+5+4+3+2+1) (sum of the years’ digits) = 0.194
0.194 x $240,000 = $46,560
And our year three calculation would be:
6 / (8+7+6+5+4+3+2+1) = 0.167
0.167 x $240,000 = $40,080
You will continue with these calculations until there is no remaining life of the asset and you reach the asset’s scrap value.
Depreciation for taxes
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. You can learn more about MACRS depreciation and review the tables on the IRS’ website.
The four methods described above are for managerial and business valuation purposes. It’s important to understand these methods. Many small-business owners will only record depreciation their accountants calculate for the tax return. This ensures the balance sheet matches the tax return, which in turn makes it easier to validate the accuracy of the 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 money each month in a business savings account — the easier it will be to replace the equipment when the time comes.
A version of this article was first published on Fundera, a subsidiary of NerdWallet.