Depreciation: Definition and Calculations
Depreciation is a measurement for capturing the value loss of an asset over time. It is an accounting and tax practice deployed by companies. They can write off a portion of the investment rather than reporting it all in year one, resulting in higher net income on balance sheets and a lower tax base. Companies may set their annual threshold amounts for depreciation.
Why Do Assets Experience Depreciation?
Assets depreciate directly from ongoing usage, causing wear and tear, or indirectly from new product models or inflation. Even an asset that remains unused loses value over time.
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What Type of Assets Qualify for Depreciation?
While various legal and tax jurisdictions may have slightly different criteria, most require the asset to meet the following:
- Ownership by the reporting party
- Business usage to generate income
- Ability to determine its useful life
- It must last more than one year
Examples of Assets that Depreciate
- Industrial machinery
- Real estate
- Computers and electronics
- Vehicles
- Office furniture
Depreciation Types with Examples
Accountants can calculate depreciation with different formulas. We have outlined the most used ones with examples.
We will use the following criteria in each example:
- Asset value: $25,000
- Salvage value: $5,000
- Expected lifespan: 5 years
Therefore:
Depreciation value = $20,000 (Asset value - Salvage value )
Straight-Line Depreciation
This method spreads depreciation equally across the expected lifespan minus the salvage value.
Example:
$20,000 (Depreciation value) / 5 (Expected lifespan) = $4,000
Therefore:
A company can write off $4,000 in depreciation annually for an annual depreciation rate of 20.00% {(Annual depreciation / Depreciation value ) x 100}
Declining Balance Depreciation
This method uses the book value of an asset and not the depreciation value. Since the value is the highest in year one before depreciation, the equal percentage value shows declining depreciation as the assets depreciate.
Example:
Declining Balance Depreciation = Book value x (1 / Expected lifespan) or 0.20%
Depreciation Year | Book Value | Depreciation |
|---|---|---|
Year One | $25,000 | $5,000 |
Year Two | $20,000 ($25,000 - $5,000) | $4,000 |
Year Three | $16,000 (20,000 - $4,000) | $3,200 |
Year Four | $12,800 (16,000 - $3,200) | $2,560 |
Year Five | $10,240 (12,800 - $2,560) | $2,048 |
Double-Declining Balance Depreciation (DBB)
This method accelerates depreciation as it multiplies the rate by two.
Example:
DBB = Book value x (2 / Expected lifespan) or 0.40%
Depreciation Year | Book Value | Depreciation |
|---|---|---|
Year One | $25,000 | $10,000 |
Year Two | $15,000 ($25,000 - $10,000) | $6,000 |
Year Three | $9,000 (15,000 - $6,000) | $3,600 |
Year Four | $5,400 (9,000 - $3,600) | $2,160 |
Year Five | $3,240 (5,400 - $2,160) | $1,296 |
Sum-of-the-Years Digit Depreciation (SYD)
This method is an alternative formula to calculate accelerated depreciation. It combines the years of the lifespan and uses the depreciation value.
Example:
- Sum of years = 1 + 2 + 3 + 4 + 5 or 15
- Year One = Deprecation Value x (5/15)
- Year Two = Deprecation Value x (4/15)
- Year Three = Deprecation Value x (3/15)
- Year Four = Deprecation Value x (2/15)
- Year Five = Deprecation Value x (1/15)
Depreciation Year | Depreciation Value | Depreciation |
|---|---|---|
Year One | $20,000 | $6,667 |
Year Two | $20,000 | $5,333 |
Year Three | $20,000 | $4,000 |
Year Four | $20,000 | $2,667 |
Year Five | $20,000 | $1,333 |
Units of Production Depreciation
This method divides the unit production by the deprecation value.
Example: $20,000 (Deprecation value) / 2,000,000 (estimated unit production over the expected lifespan) = $0.01 depreciation per unit
Depreciation Recapture Explained
Depreciation recapture is a tax provision that requires companies to report the salvage value of an asset as income once they dispose of it.
Depreciation versus Amortization
Depreciation only applies to physical assets, while amortization considers intangible assets like trademarks, patents, or intellectual property.
Conclusion
Depreciation allows companies to spread the costs of an investment over its expected lifespan. It provides them with accounting and tax advantages, which can have a material impact on operations. Accountants can use various methods to calculate depreciation, resulting in different write-off amounts to suit business requirements.
FAQs
What is an example of depreciation?
An example of depreciation is a company that invests $100,000 in machinery and expects a 20-year lifespan with a salvage value of $15,000, writing off $4,250 annually.
How is depreciation calculated?
Accountants calculate depreciation using purchase price, expected lifespan, and salvage value.
What are the three methods of depreciation?
The three primary methods of depreciation are Straight-Line Depreciation, Declining Balance Depreciation, and Sum-of-the-Years Digit Depreciation.
Is depreciation an expense or income?
Depreciation is an expense listed on the balance sheet of a company.
What items are depreciated?
Assets qualify for depreciation if owned by the reporting party, last more than one year, and have a useful life determination, while deployed by a company to generate income. Some examples are industrial machinery, real estate, computers and electronics, vehicles, and office furniture.