Nerdy takeaways
- Depreciation gives you a way to correlate the cost of an asset with its usefulness, or ability to produce revenue, year over year.
- Distributing an asset’s cost over its lifespan, instead of recognizing the entire cost at once, gives you a more accurate view of the asset’s value and your business’s profit at the end of the year. It can also have tax benefits.
- 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.
Depreciation is an accounting method that spreads the cost of an asset over its expected useful life. This helps give you a more accurate view of the asset's value and your business's profit. It can also have tax benefits.
If you're using the depreciation method, you don't record an asset's entire cost at once. Instead, you distribute its cost over its lifespan. It'll show up as a periodic expense on the income statement.
How much value an asset loses year-over-year depends on which depreciation method your business uses. Examples include straight-line, units of production, double declining balance or sum of the years' digits.
Good small-business accounting software lets you record depreciation. But the process will probably still require manual calculations. You'll need to understand the ins and outs to choose the right depreciation method for your business. If you aren't sure which method to use, your accountant can be a great resource.
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Types of depreciation
Here are four common methods of calculating annual depreciation expenses, 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 this adjusting entry 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 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 something. Production will likely vary from month to month. So 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.
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3. Double declining balance depreciation
Double declining balance depreciation is an accelerated depreciation method. It's useful when you're dealing with assets that are more productive in their early years. Businesses often use this method for depreciating equipment (if the units of production method doesn't make sense).
Formula: 2 x (1/Life of asset) x Book value = Depreciation expense
Most often used for: Vehicles and other assets that lose value quickly. It writes off an asset’s value the quickest.
Pros: Represents the accelerated loss of certain assets’ value more accurately than straight-line depreciation. You’ll get larger tax write-offs at the beginning of the asset’s life, when it’s most productive. Depreciation expenses continually decline as time goes on and the asset is less productive and/or requires greater maintenance (another write-off).
Cons: The calculations are more complex than the other methods. Usually, business owners using accelerated methods will set up a depreciation schedule. It could be a table that shows the depreciation expense for each year of the asset’s life. That way, they only have to do the calculations once.
4. Sum of the years’ digits depreciation
Sum of the years’ digits depreciation is another accelerated depreciation method. It doesn’t depreciate an asset quite as quickly as double declining balance depreciation. But it does it more quickly 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. Like other accelerated depreciation methods, it also lets you write off more of the asset’s cost earlier on.
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.
Depreciation examples
Let’s say you purchase a piece of equipment for $260,000. You anticipate using the equipment for eight years. You predict 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
You can use the calculator below to compare annual and monthly depreciation expenses using different methods.
Understanding depreciation and accounting
Depreciation is an expense. It appears as a line item on your income statement and reduces net income. 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 the cost of the asset over time on the income statement.
- Accordingly, depreciation usually doesn’t coincide with when the business buys the asset. That's true 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 plan for future business expenses
Recognizing depreciation in your financial statements has other benefits. For example, it 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 business loan.
Since you've estimated your equipment's useful life, you can predict when you'll need to buy new equipment. The earlier you can start planning for that purchase the better. For example, maybe you start setting cash aside each month in a business savings account.
» MORE: Best business budgeting software
Frequently Asked Questions
How does depreciation work?
Instead of recording an asset’s entire expense when it’s first bought, depreciation distributes the expense over multiple years. Depreciation quantifies the declining value of a business asset based on its useful life. It also balances out the revenue it’s helped to produce.
How do you calculate depreciation?
How you calculate depreciation depends on which method you use. Each has its own formula that takes into account some combination of the following figures:
- The asset’s useful life in years.
- The asset’s cost or book value.
- The scrap value of the asset.
- How many units the asset will produce over its lifespan.
What assets can’t be depreciated?
Assets that don’t lose their value, such as land, do not get depreciated. Alternatively, you wouldn’t depreciate inexpensive items that are only useful in the short term.
