What is Depreciation? Various Methods With Examples

Depreciation can be a tricky thing to understand, given that it involves a lot of calculation and tax deferments that you would rather have your accountant deal with. However, knowing how your assets depreciate over time is a great knowledge to have when making important financial and tax decisions for your company.

If you ask your accountant about depreciating the asset that your company owns, he would probably recommend phasing it out over the years until salvage value, instead of depreciating the entire sum in one go. This is done so that some of the tax expenses that your company is liable for can be offset with the depreciated value of the assets you own.

In a way, while depreciation eats away at the assets of your company, it also helps you to save some quanta of the taxes that you would otherwise be paying. This is the primary reason that there exist so many different ways to calculate depreciation for various assets, based on what they are (machinery or property, for example).

Let’s understand that hype around depreciation by covering the following topics:

• What is Depreciation?
• Various Assets and Their Depreciation
• What is Schedule of Depreciation?
• Various Types of Depreciation Methods
• Comparison Between Depreciation Methods

What is Depreciation?

Depreciation is a term in accounting that refers to the process of allocating the cost of an asset your company bought (like machinery, heavy equipment, property, etc.) over the period of its lifecycle. Every asset has a lifecycle over which it serves its purpose. Each year, the value of that asset declines with use. As such, its value must then be adjusted accordingly so that the revenue it generated over its useful life can be tied meaningfully to the cost/expense that went into using it.

Depreciation helps companies in fanning out the cost of an expensive asset over a period of a few years while generating revenue and saving taxes on it. For example, for purchasing heavy equipment worth $10,000, let’s say the annual depreciation observed was $1,500. Things being so, the rate of depreciation would be 15% - meaning that the asset would lose 15% of its current value each year.

Let’s understand assets and their depreciation in better detail.

Assets and Their Depreciation

Asset is the name given to anything that your company owns – anything in the rightful ownership of your company is an asset. It can be a tangible (or physical) asset, like computers or other machinery, cars, or freight trucks; it could be an intangible asset as well, like intellectual property, patents, and such items that belong to your company but do not exist physically. Every kind of asset your company owns can be bought or sold, used or discarded.

The interesting thing to note is that while you can depreciate your tangible assets (like property), your intangible assets can also be depreciated. In the case of intangible assets, depreciation is termed amortization.

However, according to the IRS, there are certain criteria that an item needs to meet for it to be called an “asset” to your company:

• Your company must own it
• Your company must use it to generate income/revenue or for doing business
• Your company determines the lifecycle of the item
• Your company expects it to last for more than a year

An example of the assets that your company can depreciate are vehicles, office equipment like computers and projectors, owned property from where business is being conducted, a fleet of vehicles, etc. In fact, there is a schedule of depreciation that is created for a comprehensive view of the depreciating assets at every company. Let’s understand that in detail.

What is Schedule of Depreciation?

The Schedule of Depreciation is a table that charts the depreciation of an asset over the years that it serves your business. It also tabulates the current value of the asset, the deductions that have happened until now, and the method that has been used to calculate depreciation on that asset.

Sometimes, the Schedule of Depreciation can be extended to include more than one asset, showing a comprehensive view of everything your company owns, and how much every asset has depreciated, the useful life left of each asset, etc.

The following information can be gleaned from a well-made Schedule of Depreciation:

• Asset details, such as cost, date of purchase, item code, etc.
• Useful life of the asset
• Salvage value (the salvage value of an asset is the price you will receive when you sell the asset at the end of its useful life)
• Method of depreciation used

Thus, the Schedule of Depreciation is basically a summary of the current values of your assets. Let's now understand the various methods used for calculating depreciation.

Various Methods of Depreciation

There isn’t just a single method of depreciation used by accountants. Based on the kind of asset and IRS requirements, companies decide on the type of depreciation they want to apply to their assets and stick to that. IRS requires that throughout the tax filings, a single method of depreciation be used; that makes companies maintain their books using a different method of depreciation sometimes.

Let’s understand the five major methods of depreciation used by accountants with respective examples.

The Straight-Line Method

This is the simplest method of calculating the depreciation of an asset. In concept, this method involved reducing the same amount of value from the cost of an asset every year; that is, the cost of the asset is divided evenly over the span of its useful life until it reaches its salvage value.

Small businesses that do not employ the services of accountants for depreciating their assets employ this method, generally because the calculations are simple and straightforward. With that said, this method may not give the best tax benefit as compared to other depreciation methods.

In the graph below, the vertical represents asset value whereas the horizontal represents its year of use. As you can observe, the asset starts off with a value of $10,000 that depreciates evenly each year and creates a straight line on the graph, which gives this method its name.

The formula for calculating straight-line depreciation is as follows:

Straight Line Depreciation = (Asset Cost – Salvage Value of Asset) / Life of Asset

Let’s understand this with an example. Say that a company invests $50,000 in new servers on-premises for the purpose of improving the performance of its digital assets and managing data. The servers have a life of ten years, and a salvage value of $1,500. The straight-line depreciation for these servers would be:

Straight-line depreciation = ($50,000 - $1,500) / 10

Straight Line Depreciation = $4,850 per year for 10 years.

Tabulating this data:

Since the asset depreciates equally each year, the number $6,929 remains the same over the 7 years of depreciation. This number changes each year with other depreciation methods.

The Double-Declining Balance Depreciation

This method follows a slightly different concept in declining the value of an asset than the straight-line method. With this method, a business primarily focuses on gaining the most out of the asset in the first year itself and depreciating the remaining book value over the rest of the useful life of that asset.

In this method, the value obtained from the straight-line depreciation is doubled and depreciated in the first year of asset deployment. For the subsequent years, the percentage depreciation is calculated and reduced from the remaining book value of the asset.

Usually, the business that wants to quickly recover the value of the asset within a few years of purchase uses the double-declining balance depreciation method. Let’s understand this by continuing the example of server purchase earlier.

The initial purchase value of the servers was $50,000, and the salvage value was $1,500. Let’s consider the useful life of the servers as 10 years. The depreciation calculated using the straight-line method was $6,929. With these numbers, the percentage depreciation can be calculated as follows:

Depreciation rate as per straight-line method = ¹/₁₀

Depreciation rate of servers = 10%

As per the double-declining balance depreciation method, the asset is depreciated doubly, which makes the depreciation rate be (10% x 2) = 20%. Now, let’s calculate seven years’ worth of depreciation on the asset. Here is how the first five years will look like:

In the first year itself, your company writes off a major $10,000, which keeps decreasing in the subsequent years. By the end of the final year, the salvage value of the servers will have been written off.

Sum of The Years’ Digits Depreciation

This method also uses the concept of depreciating much of an asset’s value in the initial years itself. In a way, it is similar to the double-declining depreciation method; however, there is one fundamental difference. While the double-declining depreciation method significantly recovers the value of an asset in the first year itself, the SYD method has its depreciation a little more spread out over the asset’s useful life, although still giving the company the benefit of early recovery.

In this method, you add the digits in the number of years of an asset’s useful life. This then is used to calculate the fraction that translates into the depreciation rate, which then applies to all the calculations. The formula to calculate the sum of the years’ digits depreciation is as follows:

Depreciation = (Remaining lifespan/sum of the years’ digits) x (cost of assets – salvage value)

An example would give a better understanding. Consider the server purchase example. The cost of assets was recorded at $50,000, and the salvage value at $1,500. The useful life of the servers was 10 years. With this data, depreciation for the first year would then be calculated as follows:

Depreciation = (10 / 55) x ($50,000 - $1,500)

Depreciation for the servers for the first year = $8,818

In the next five years, the servers will depreciate as per the data tabulated below:

Notice how in the first year, about $8,900 were depreciated while in the subsequent year, only about $6,500 were depreciated from the asset value.

Units of Production Depreciation

The units of production depreciation method is a highly practical way of planning to depreciate an asset. The value of the asset is weighed in the work it actually does to create something that generates revenue for the company. For as long as the asset is working and producing, it would depreciate faster. For the times it is idle, it would be depreciated slower.

While this method sounds like a justifiable way to depreciate an asset, it comes with its own problems. For the units of production that can’t really be delineated or universally identified, this method wouldn’t calculate accurate results. For example, the number of hours for which equipment was functional could be considered as a universally accepted metric for calculating depreciation using units of production method.

The formula for calculating depreciation using this method is as follows:

Depreciation = (Value of asset – salvage value) / number of units produced during the useful life

This formula shows the amount of money going in to produce a single unit using the asset in question.

Let’s consider the server example again. The initial value of the servers was $50,000 while the salvage value was $1,500. The useful life of the servers was 10 years. Let’s say that the manufacturer rates the servers as usable up to 75,000 hours over a period of 10 years. Calculating the depreciation using units of production would then be thus:

Depreciation = ($50,000 - $1,500) / 75,000

Depreciation = $0.65 per hour of server time

Let’s say that for the first year, the servers were used for a total of 6,000 hours. That would make the depreciation to be as follows:

Depreciation = $0.65 x 6,000

Depreciation = $3,900

Similarly, based on the number of hours the servers were operational for the subsequent years, respective depreciation can be calculated. Let's say that for the subsequent four years, the annual operational hours for the servers were 5,500, 7000, 6,500, and 5,000 respectively. The depreciation is tabulated below:

Modified Accelerated Cost Recovery System

This method of depreciation is the one prescribed by the IRS for depreciating tangible property in the United States. The rates of depreciation are stipulated in IRS Publication 946, Appendix B. The assets are classified according to the classes they belong to, and their useful life is stated accordingly, using which depreciation can then be calculated. A summary of the information in the IRS publication is as follows:

It is better to let an accountant handle this depreciation for you because it involves complex references and calculations.

Comparison and Inferences from Different Depreciation Methods

Each method of calculating depreciation is different, and suitable for its own set of requirements. The table below captures the yearly values of depreciation using the four methods discussed earlier on the same example:

While the straight-line method has a constant value, the double-decline method depreciates in an accelerated manner in the first year. The sum of the years’ digits method also helps the company in quicky recovery, however, it isn’t as steep as double-decline. The units of production method totally depend on the server time recorded.

Conclusion

Depreciation is a way for companies to work towards saving the taxes on assets by depreciating them. It is best to involve a practiced accountant to handle numbers that span over years to come in order to avoid inaccuracies.

Key Takeaways

Depreciation can be termed as the process using which an accountant spreads the value of an asset over its useful life for the purpose of accounting and taxes, in order to save some of the taxes a company is liable for. This can be done using five methods:

• Straight Line Method
• Double-decline Method
• Sum of the years' digits method
• Units of production method
• Modified accelerated cost recovery system

Using any of the five methods listed above, depreciation can be calculated for any asset your company owns.

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