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Introduction to Depreciation Methods

Welcome to our introduction to depreciation methods, where we teach you everything you need to know about that pesky thing called depreciation. Admittedly, it may not be the sexiest of concepts, but we think it’s important for every business owner to understand the basics. For one, it’s interesting, but far more importantly, it can significantly impact your bottom line and is an important consideration in tax optimization and business strategy.

So, strap on your thinking cap and let’s dive in to all things depreciation.

What is depreciation?

Depreciation is a term used to describe the allocation of costs over an extended period of time. Costs that can be depreciated are those regarding fixed assets, which are items purchased for a business’s long-term use that have a useful life of one year or more. There are several guidelines and tables available online to learn the correct useful life of an asset. Common fixed assets include equipment, office furniture, machinery, computer software, buildings, and vehicles. Furniture, fixtures, and other smaller assets are typically fully depreciated within seven years, while larger assets, like buildings and roofs, may have useful lives up to 39 years.

Unlike smaller day to day purchases, these large, long term assets aren’t expensed when they are bought. Instead, the expense is spread out over time via depreciation, which works by reducing the value of the asset as it ages or decays. The amount that is expensed in each period is equal to the amount of depreciation in that period, and the net value of the asset on the balance sheet equals the purchase price minus total depreciation to date.

One of the reasons this is important is because it can impact your tax burden. Even though depreciation in a given period isn’t tied to actual cash leaving your bank account, it is still an expense on your income statement. (Accountants refer to this as a non-cash expense.) Higher expenses decrease your net pretax profit, which decrease your taxes, which increase the cash in your bank account. So, the way you manage depreciation has important tax implications.

Aggressive depreciation

Aggressive depreciation methods, that is, depreciation methods that decrease the value of an asset more quickly, increase expenses in the near term, thus lowering net income and the resulting tax liability in the current period in exchange for lower expenses and higher taxes in the future. Less aggressive treatments result in lower expenses today but will increase expenses in the future.

Another impact of the different methods is regarding the net value of assets on the balance sheet. With aggressive depreciation the net value of an asset on the balance sheet will decrease more quickly, and with a slower depreciation method the net value of the asset will decrease more slowly. (Remember, the value of the asset is its purchase price minus total depreciation.) Eventually, however, the differences will balance out and you will end up with the same value.

Deciding whether a company will benefit from more aggressive, or less aggressive, treatments of depreciation depend on the business owner’s goals and the regulatory structure.

An angry cat, symbolic of aggressive depreciation methods.
An aggressive depreciation method isn’t the same as an aggressive cat. Don’t mistake the two.

Types of depreciation methods

As discussed, how assets are depreciated can impact both a business’s bottom line and their balance sheet. According to the Generally Accepted Accounting Principles, or GAAP, there are four different methods. (GAAP is like the constitution of American accounting.) Before choosing the best method, you’ll want to discuss your short-term and long-term business goals with your accountant.

Straight Line Depreciation

The most common way to calculate depreciation expense is to use the straight line method which depreciates an asset by equal amounts each year based on the purchase price, useful life, and salvage value. That is, the value of the asset when you are ready to get rid of it. For example, if a business purchased an $11,000 copier with a useful life of 5 years that will be wort $1,000 at the end of its life, they would record $2,000 of depreciation ($10,000 / 5 years) per year. Straight line depreciation isn’t considered aggressive or passive, it is sort of the baseline methodology.

Declining Balance Depreciation

Declining balance depreciation is considered an aggressive method because it results in higher expenses in the early years and lower expenses in the later years. In this method a constant percentage of deprecation is applied to the net book value of the asset to calculate the expense. For example, if an asset worth $20,000 with a salvage value of $1,000 depreciates 40% per year the calculations would be as follows:

  • Year 1 Depreciation: $20,000 * 40% = $8,000 (So the net asset value is now $12,000.)
  • Year 2 Depreciation: $12,000 * 40% = $4,800 (So the net asset value is now $7,200.)
  • Year 3 Depreciation: $7,200 * 40% = $2,880 (So the net asset value is now $2,880.)
  • Year 4 Depreciation: $2,880 * 40% = $1,152 (So the net asset value is now $1,152.)
  • Year 5 Depreciation: $152 (Because the salvage value is $1,000.)

As you can see, the expense is decreasing each year, and it is stopped when the value of the asset hits the salvage value.

A machine sprays sparks as it is used, symbolic of depreciating machinery.
If you buy machinery for your business, be sure you depreciate it properly! Talk to your bookkeeper or accountant right away. Also, always protect yourself from sparks…

Sum of the Years Method

Another way to calculate depreciation that is more aggressive than the common straight line method, is the sum of the years’ digits method. In this method you use a formula to convert the useful life of the asset to a percentage that changes each year which you then multiply by the original cost minus the salvage value. The formula is a ratio and a bit odd, so bear with us. For the denominator you add up the digits for each year of the useful life. So, if an asset has a 5 year useful life it would be (year) 5+ (year) 4 + (year) 3 + (year) 2 + (year 1) = 5+4+3+2+1 = 15. For the numerator, you use the same digits, starting with the largest one in the first year. So if the asset is worth $20,000, has a salvage value of $1,000 and a useful life of 5 years, the calculation would be as follows:

  • Year 1 Depreciation: $19,000 * (5/15) = $6,333
  • Year 2 Depreciation: $19,000 * (4/15) = $5,066
  • Year 3 Depreciation: $19,000 * (3/15) = $3,800
  • Year 4 Depreciation: $19,000 * (2/15) = $2,533
  • Year 5 Depreciation: $19,000 * (1/15) = $1,266

As you can see, the depreciation decreases each year, but the total equals the purchase price minus the salvage value. (With a little bit of rounding error.)

UOP Depreciation

The units of production method of depreciation is most often used in the manufacturing industry because it calculates the annual expense based on the actual output of the machine or equipment relative to its total capacity over time. For example, if a $10,000 piece of machinery is able to package 10,000 units, then each unit accounts for $1 of the machine’s life. So, if the machine produces 500 units in a given year, depreciation expense will be $500.

Section 179

Not a GAAP method for calculating depreciation, but an important option to consider for business owners, is using the Internal Revenue Code’s (IRC) Section 179. This option allows businesses to expense the entire cost of the asset in the first year it’s purchased. This option lowers the taxable income in that year, which can be particularly beneficial to new business owners.  For the tax year 2023, business owners can expense the cost of fixed assets up to $1,160,000.

Key Takeaways on Depreciation

  • The method a business uses to depreciate assets will depend on the long and short-term goals of the business owner.
  • The most common way to calculate depreciation is the straight-line method.
  • Depreciation expenses lower a company’s tax liability by reducing net income.
  • More aggressive depreciation results in lower taxable income in the short term, but higher taxable income in the future.
  • The net value of an asset on the balance sheet is it’s original value minus accumulated depreciation.
  • In some cases, business owners can deduct the total cost of a newly purchased asset by electing to use IRC Section 179.

So there you have it, everything you ever wanted to know about depreciation. (And potentially some things you never wanted to know.) Want to continue with your learning? A great next step would be to review balance sheets or income statements. (Income statement is another term for profit and loss, in case that one threw you for a loop…)

Who are your authors? We’re My OC Bookkeeper, Orange County’s premier bookkeeping service provider. We do everything from financial modeling to day to day bookkeeping, to complex bookkeeping clean ups. Need help with your books? Reach out today!

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