Depreciation is an accounting process that’s used to establish the book value of fixed assets. It apportions the cost of an asset over the span of its useful life as its value decreases incrementally over time due to factors such as wear and tear. The University of California, Davis indicates that the depreciation process accounts for the loss of value on a company’s balance sheet, income statement, other financial statements and tax returns.
What Depreciation Means for Your Business
Assets can be intellectual property or physical property, such as equipment or buildings. The depreciation process of intellectual property is referred to as amortization. Calculation of depreciation begins with the asset’s capitalization date when it’s put into service. It spreads over the useful life of the asset.
The IRS generally prohibits a business from claiming a tax deduction for the entire cost of an asset in its first year of service. It requires that you spread out the amount of depreciation over a period of years. You can deduct a percentage of the cost each year during this period.
IRS rules specify that you must own the asset, and you must use it in an income-producing activity. It must also have an anticipated life span of more than one year.
The Accelerated Cost Recovery System, or ACR, was used to depreciate property placed in service before 1987. The Modified Accelerated Cost Recovery System, or MACRS, is used for property placed in service after 1986. MACRS sets the number of years over which various assets must be depreciated.
Common Types of Depreciation Methods
Generally accepted accounting principles (GAAP) requires that businesses must record annual depreciation of tangible assets based on a depreciation schedule. Four depreciation methods are commonly used.
Straight-line Depreciation Method
The straight-line depreciation method is the simplest depreciation calculation. This depreciation formula involves dividing the cost of the asset equally over its expected years of use.
A $10,000 asset with an anticipated useful life of five years would work out to depreciation of $2,000 per year. But this assumes that its salvage value – what you anticipate its value to be after depreciation is complete – is zero.
Your $10,000 asset might have a salvage value of $1,000, so the equation would then work out like this because the salvage value must be subtracted: $10,000 less $1,000 is $9,000, and $9,000 divided by five years would work out to $1,800 a year.
Double Declining Balance Depreciation Method
You might want to use an accelerated method of depreciation if you want to depreciate the asset more heavily in its first years of use. The double declining balance depreciation method is an accelerated depreciation method. It accounts for the likelihood that an asset is more productive in its early years before it begins to age and near the end of its useful life.
The depreciation factor is twice that of the straight-line method. The depreciation rate is calculated in the first year as 100 percent of the asset’s value divided by its useful life times two. The depreciation claimed in year one must then be subtracted from the asset’s value in year two.
Units of Production Depreciation Method
The units of production depreciation method depreciates an asset using the total number of hours it’s used over its useful life or the number of units it will produce during that period of time. Divide the number of units produced by the anticipated life of those units and multiply the result by its cost less its salvage value.
Sum of Years' Digits Method
Add the digits of each year of the asset’s life if you elect to use the sum of years' digits method.
- For example, you would add 5 + 4 + 3 + 2 + 1 if the asset will be in use for five years. The sum of the years' digits would be 15.
- Now find the percentage of depreciation for each year. Each year is divided by the sum of the digits. The percentage is obtained by dividing 5 by 15 to get a percentage of 33.34 in the fifth year. Divide 4 by 15 for a percentage of 26.67 in the fourth year. Continue down to 1.
- Now, calculate the depreciation expense by multiplying the cost of the asset by the appropriate percentage of depreciation for each year.
The Bottom Line
Any of these methods will determine the decrease in value of an asset over time. The method you choose can depend on how quickly you want to claim depreciation, the complexity of your small business and what a particular asset is being used for.
Beverly Bird has been writing professionally for over 30 years. She is also a paralegal, specializing in areas of personal finance, bankruptcy and estate law. She writes as the tax expert for The Balance.