Depreciation

Depreciation is an accounting method to decline an asset’s value over its useful life. Learn when to use straight line, double declining, units of production, and sum of years. Understand the formulas and how to find your accumulated depreciation balance.

What is Depreciation?


Depreciation is an accounting method used to reduce a tangible asset’s value over its useful life. Accountants depreciate an asset, such as a factory or piece of machinery, to show that a portion of its original value has been used up.

For small expenditures, the full value is expensed in a given accounting period. For example, spending $500 on office supplies will show up as an expense on the income statement. However, purchasing a $500,000 piece of factory equipment would dramatically impact the income statement and not adequately capture how long the equipment will be used for.

As such, these expenditures are capitalized, a process of adding an expenditure to the balance sheet as an asset. Businesses depreciate assets for both tax and business purposes.

Depreciation influences both the income statement and balance sheet. Accumulated depreciation is a balance sheet account that shows the total amount of depreciation allocated to an asset, whereas depreciation expense is a non-cash expense that shows up on the income statement.
Depreciation is an accounting method used to reduce a tangible asset's value over its useful life.

There are several depreciation methods, with the most common four being the straight line method, the double declining method, the units of production method, and the sum of years digits method.

In this post, we will define depreciation, show you how to calculate depreciation in different situations, and talk through depreciation and accumulated depreciation.

Amortization is a similar process to reduce the value of an asset over time. Depreciation is used for tangible assets, where amortization is used for loans and intangible assets like patents, trademarks, copyrights, and goodwill.

How to Calculate Depreciation


In this section, we will walk through how to calculate depreciation and define the most important terms and concepts. Depreciation is related to an asset, such as a building, vehicle, or piece of machinery.

Depreciation expense refers to an expense that lowers your profit for the given accounting period. This non-cash activity is expensed in the current period and lowers your profit, and thus, your taxes.
Accumulated depreciation is a contra account on the balance sheet that holds the total depreciation allocated to the asset. Purchase price minus accumulated depreciation is equal to the book value of the asset. The normal balance of this account is a credit.
Depreciation schedule refers to a table made to track the change in depreciation and book value given your chosen accounting method. This is a tool that helps accountants and managers keep track of their depreciation, make sure they are reporting the right profit on the income statement, and showing the correct book value on the balance sheet.
Purchase price refers to the price that you paid for the asset in the first place. If you purchased a work van for $35,000, that is your purchase price. It’s important to include taxes and fees to correctly capture the full price paid.
Book value refers to the value of the asset as it sits on your balance sheet. On the day of purchase, book value equals purchase price. As the asset is used, the book value of the asset will decrease through the depreciation process. (Hey! That’s what we’re here to learn about.)
Useful life refers to the amount of time that the asset can be used for. For instance, if a work van may have a useful life of 5 years and a factory may have a useful life of 20 years.
Salvage value refers to the value, if any, at the end of the useful life. Some assets have value at the end of their useful life, others need to be repaired, and others are simply discarded. This term is often called a residual value.
Depreciation rate refers to the amount depreciated in each year compared to the total depreciation. This value is expressed as a percentage. The formula is 1 / Useful Life. For example, an asset that has a useful life of 5 years would have a depreciation rate of 20% per year.

Next, let’s look at examples of the journal entries (debits and credits) for depreciation. In this example, the company purchased a building for $2,500,000 for cash. The building has a useful life of 20 years.


Journal Entries for Asset Purchase

  • Debit: $2,500,000 to Fixed Assets
  • Credit: $2,500,000 to Cash

Journal Entries for 1st Year Depreciation

  • Debit: $125,000 to Depreciation Expense
  • Credit: $125,000 to Accumulated Depreciation

As a reminder, a debit will increase an asset account on the balance sheet and a credit will decrease an asset account on the balance sheet.

Great! Now we’re going to dive into the different methodologies and more in-depth examples.


Examples of Depreciation


Now we are going to explore three examples of depreciation. In our first example, Company A purchases a fixed asset for $70,000.

The useful life of the asset is 5 years and a salvage value of $20,000. It’s expected to produce 500,000 units over its useful life and the asset produced 87,000 units in its first year.

We will walk through how to depreciation the assets using the straight line method, which is the simplest formula.


Straight Line Depreciation


The straight-line depreciation method relies on decreasing an asset’s value equally over its useful life.

The name refers to the fact that the book value of the asset follows a straight down, starting at the purchase price and ending at the salvage value.

Straight line depreciation decreases an asset's value equally over its useful life.

The straight line depreciation formula is:


Straight Line = (Asset Cost - Salvage Value) / Useful Life


Here is the depreciation calculation using straight line depreciation and the information given about.


Straight Line = ($70,000 - $20,000) / 5 years

Straight Line = $50,000 / 5 years

Straight Line = $10,000 / year


Under this treatment, we would deduct $10,000 of asset value every year and hold that value in accumulated depreciation. Here is the math:

  • Year 0: $70,000 book value and $0 accumulated depreciation
  • Year 1: $60,000 book value and $10,000 accumulated depreciation
  • Year 2: $50,000 book value and $20,000 accumulated depreciation
  • Year 3: $40,000 book value and $30,000 accumulated depreciation
  • Year 4: $30,000 book value and $40,000 accumulated depreciation
  • Year 5: $20,000 book value and $50,000 accumulated depreciation

The straight line method provides the same depreciation expense (dollar amount) and depreciation rate (percentage) in the first year as the second year, third year, etc.

Remember: Book value + accumulated depreciation always the asset's purchase price.


Double Declining Balance Depreciation


The double-declining balance method, also called the double declining method, is an accelerated treatment done by doubling the straight line depreciation rate.

For each year, we have to calculate the math all over as the book value does not follow a straight line under this treatment.

Double declining balance doubles the striaght line depreciation rate.

The double declining balance (DDB) formula is:


Double Declining Balance = 2 x Straight Line Depreciation Rate x Book Value


Straight line depreciation rate is the percent depreciation under the straight line method above. This is calculated by 1 divided by the useful life. In our case, it’s 1 / 5 or 20%. So double this value would be 40%.

We will be using 40% multiplied by the book value for each year. Here is the math for the first year:


DDB = 40% x $70,000

DDB = $28,000


Since we depreciated $28,000 in the first year, the book value for year two is now $42,000. Let’s do the math for the second year now:


DDB = 40% x $42,000

DDB = $16,800


The $42,000 book value less $16,800 in depreciation is $25,200, which means that depreciation expense in year 3 would be $5,200. Why? Because we cannot depreciate past our salvage value.

Here are all of the depreciation expenses side by side to show how it’s declining in nature:

  • Year 1: $28,000
  • Year 2: $16,800
  • Year 3: $5,200
  • Year 4: $0
  • Year 5: $0

This is an accelerated depreciation method compared to straight line depreciation. The company will show higher depreciation expense and higher depreciation rates, but for a shorter number of years. The net impact over the asset’s useful life is unchanged.


Units of Production Depreciation


The units of production depreciation method relies on production output, instead of time, to calculate depreciation.

The amount of depreciation is based on two factors: the total number of units the asset can produce over its lifetime and the number of units actually produced in a given period.

Units of production is a depreciation based on asset's output, not time.

The units of production formula is:


Units of Production = (Total Depreciation / Estimated Lifetime Units) * Actual Units Produced


Let’s dig into the numbers using the example for Company A.


Units = ($50,000 / 500,000) * 87,000

Units = $0.10 * 87,000

Units = $8,700


As you can see, the company expected to produce 100,000 units per year (500,000 lifetime units over a 5 year useful life). That number (100,000 * $0.10 per unit) would have given us the same $10,000 as the straight line method.

Since we produced fewer than 100,000 units this year, the depreciation expense was lower than straight line. If the number of units produced next year is higher than 100,000, the depreciation expense would be higher than straight line.


Sum of Years Digits Depreciation


The sum of the years digits depreciation method (SYD) is an accelerated depreciation method that relies on summing the digits in the useful time to calculate the depreciation rate.

This method, also called the sum of years depreciation method, provides higher depreciation in earlier years and lower depreciation in later years. For an asset with a 5 year useful life, here are the digits: 5, 4, 3, 2, and 1.

You would sum those digits (5 + 4 + 3 + 2 + 1 = 15) and use that as the denominator. For each year, you would take a digit (starting with the largest digit for the first year and working your way down) to get the depreciation rate.

Sum of years digits is a system where you sum the digits in the useful life, and use this total to calculate the depreciation rate.

Example with 5 year useful life:

  • Year 1: 5/15 = 33% depreciation
  • Year 2: 4/15 = 27% depreciation
  • Year 3: 3/15 = 20% depreciation
  • Year 4: 2/15 = 13% depreciation
  • Year 5: 1/15 = 7% depreciation

All of these percentages need to sum up to 100%.

The digits method provides a quick way to get an accelerated depreciation schedule. For our example company with $50,000 of total depreciation, their yearly depreciation would be:


Year 1: $50,000 * 33% = $16,500

Year 2: $50,000 * 27% = $13,500

Year 3: $50,000 * 20% = $10,000

Year 4: $50,000 * 13% = $6,500

Year 5: $50,000 * 7% = $3,500


As a quick check, let’s make sure these values sum to $50,000.


Total Depreciation = $16,500 + $13,500 + $10,000 + $6,500 + $3,500

Total Depreciation = $50,000


Now we can be sure that we calculated the math correctly using the sums method correctly.


Final Thoughts


Depreciation is a very important concept in corporate accounting and taxes. In its most simple form, depreciation captures the loss of value due to wear and tear, deterioration, or obsolescence of a piece of property (IRS).

Executives, managers, investors, accountants, and others want to understand the full cost of purchasing and using an asset. These stakeholders will pay careful attention to an asset’s useful life, upfront cost, maintenance cost, and productivity.

Here are some key takeaways about depreciation:

  • The book value of an asset refers to its current value as stated on a company’s balance sheet.
  • The useful life of the asset refers to the number of years that it will be used and is used to calculate the yearly rate of depreciation.
  • Salvage value, also called residual value, is an asset’s value (if any) at the end of its useful life.
  • Depreciation expense is the non-cash expense that lowers profit on the income statement, accumulated depreciation is the contra account on the balance sheet that holds the total depreciation for an asset.
  • Straight line is the simplest form of depreciation and draws a straight line from the purchase price to the salvage value over its useful life.
  • Double declining takes twice the straight line depreciation rate and applies it, accelerating the depreciation over fewer years.
  • The units of production method relies on production output, instead of time, to calculate depreciation.
  • The sum of the years digits method relies on summing the digits in the useful time to calculate the depreciation rate.

The Internal Revenue System (IRS) has rules governing how assets are depreciated over time because depreciation expenses is a tax deduction. There are several methods available to businesses and accountants, each with their pros and cons.

Depreciation expense can have a large impact on the profits reported, and thus the taxes due, for a business each year.

Business owners and accounting professionals should make decisions about purchasing fixed assets by considering the cost of the asset, repairs, maintenance, and the tax implications resulting from depreciating the asset.

Ultimately, depreciation accounting provides a clearer understanding of the true cost of purchasing an asset.

Keep in mind that rules for depreciation vary significantly based on geography, type of taxpayer, and type of asset. Please consult a tax professional for specific information relating to your tax calculations and tax return.

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