Introduction to Depreciation Methods

A beat up old car, symbolic of the impact of depreciation methods in accounting.

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!

Want to learn more about us? Check out the video below!

What are Financial Statements? (An Intro to the Financial Statements)

A business person writing on and reviewing documents that are symbolic of the financial statements.

Introduction to the Financial Statements

If you want to understand accounting, or business in general, then one of the first things that you must learn is how to read financial statements. The financial statements provide summary data (accumulated through day-to-day bookkeeping and accounting) that can tell you a great deal about a company’s financial well-being and the nature of its operations.

For public companies, the financial statements are available to the public in their annual and quarterly reports, also known as 10-Ks and 10-Qs. For private businesses, the financial statements aren’t usually available to the public, but they can be seen in internal documents, internal accounting software, and often-times tax returns. (Strictly speaking that can be said for public companies as well, but the important point is that private companies don’t have formal 10-Ks and 10-Qs that you can find on the web.)

Quick Tip: A great way to learn more about financial statements is to review some real-world examples. If you want to see some 10-Ks from public traded companies check out the SEC’s EDGAR portal where you can search for a public company’s official financial filings. There is a lot of information in an annual or quarterly report (10-K or 10-Q), but if you go through it closely you should be able to find the financial reports – or just check the table of contents if you want to save some time.

So, what are these mysterious financial reports? The three primary statements are the Income Statement (also known as a Statement of Profit and Loss), the Balance Sheet, and the Statement of Cash Flows. (Some public companies may also use a Statement of Changes of Equity, but that is beyond the scope of discussion here.) When reviewed in conjunction, these reports can give a remarkably holistic view of a company, regardless of its size or what it does. In fact, you can learn quite a bit about a company just looking at one or two of these reports, in particular the income statement and the balance sheet.

We will go through each of the documents in turn – so strap on your accounting hat and get ready for some financial statements.

The Income Statement

The income statement, also known as the statement of profit and loss or simply the P&L, is surely the most well-known financial statement. If you want to check out a company’s profitability, or how much revenue it has, or how many expenses it has, then the income statement is what you want. The concept is really quite simple: it starts with the revenue at the top, then begins deducting expenses until you end up with net income, or net loss, which is the amount of money gained or lost after accounting for all of the expenses.

The income statement is made up of flow variables, which is a fancy way of saying that an income statement expresses activity through time, for example a month, or a quarter, or a year. So, when you read an income statement, it is always important to check what the time frame is. (Needless to say, the income statement on an annual report should be for a year and on a quarterly report should be for a quarter.)

A sample income statement showing revenue, followed by several different expenses to get to the net profit.
Sample income statement.

As you can see, an income statement may include some strange vocabulary that you may not be used to. To help with this we’ve put together some definitions which should help to keep things clear – but don’t get too bogged down on any one line item, the most important thing to remember is the basic concept. That is, you start with revenue and then begin pulling out the expenses one by one until you get to your net income, also known as profit.

Cost of Goods Sold (COGS)

You may see COGS listed as an expense just under revenue at the top of an income statement. COGS is an expenses category that some businesses use to describe the internal cost of items they sell. If you buy and then resell shoes, for example, then the cost of buying your shoes is your cost of goods sold, which of course must be deducted from your revenue when trying to determine your profit.

SG&A (Selling, General, & Administrative)

As noted above, SG&A stands for selling, general, and administrative expenses. This can be quite a broad category of expenses, depending on how many unique line items you want on your income statement. It can include anything that would be considered a general or administrative expense like employee salaries, rent, or the cost of office materials and supplies, as well as selling costs like commissions.

Gross Profit

If a company uses COGS, then it will add a subtotal for gross profit which represents the profit after deducting COGS, but before deducting the remaining expenses. This is known as gross profit accounting. (Take look at this article from Investopedia for a bit more info on the difference between gross profit and net income, an important topic.)

EBITDA

EBITDA stands for earnings before interest, taxes, depreciation, and amortization. This represents a subtotal describing profits before deducting the aforementioned amounts and can be useful when undertaking financial analysis or analyzing a company in a bit more detail.

EBIT

This is the same as EBITDA but with the depreciation (D) and amortization (A) deducted.

Depreciation & Amortization

These are slightly more advanced accounting concepts that represent the amounts deducted as a consideration of the value lost via the depreciation of your equipment or any intangible assets (for example trademarks) that you might own. Unlike most of the expenses on the income statement, these are non-cash expenses, that is, they don’t represent actual cash being lost. We’ll learn a bit more about this concept when we discuss the statement of cash flows later in the article.

Net Income / Net Earnings / Profit

Three ways of saying the same thing, that is, the amount of money left over after deducting all of your expenses.

So those are the income statement basics – for a more detailed description take a look at this blog post which takes a deep dive into all things Income Statement.

The Balance Sheet

The balance sheet is the second most famous financial statement, and when presented alongside the income statement can give a pretty good picture of a company’s financial position. (Although not perfect, for that you need all the statements.)

The balance sheet displays the value of a company’s assets, liabilities, and shareholder’s equity at a given moment in time. This is distinct from the income statement, which describes values that accumulated through a period of time. That is to say, the balance sheet from Dec. 31 describes the value of a company’s assets, liabilities, and equity at the end of that day, and the balance sheet on Dec. 20th describes the values at the end of that day. This may seem a bit confusing, but the key point is that the asset, liability, and equity accounts on the balance sheet represent a store of value that changes through time, not the amount of the actual change.

For example, imagine you bought a multi-million dollar piece of equipment. This is an asset that your business owns and therefore must be displayed on your balance sheet. Just like your car or your house or your computer, this asset will likely lose value over time, so in order to get a good understanding of your company’s financial standing at a given moment it will be key to see the value of the asset at that particular moment in time. Another example would be a loan. On day one of a loan you owe the entire amount, so the entire amount will be shown on the balance sheet. Three years into the loan it will (hopefully) be much smaller, so the amount on the balance sheet will be the remaining balance of the loan after three years.

A bronze bust of lady justice holding scales, symbolic of the balance sheet, one of the financial statements.
Lady justice loves balance sheets.

What is the point of all of this? The point is to show the assets that a company owns, the liabilities that a company owes, and the value that has either been invested in the company or that the company has generated through its operations, (the final concept being the equity). By looking at this one can get a much better understanding of a company’s financial position. Does it have a ton of debt? Does it have a great deal of assets? What kind of assets does it have? What kind of debt does it have? A balance sheet can help to answer these questions.

Quick Tip: Normally, when the balance sheet is displayed alongside the income statement it will represent the last day in the period shown via the income statement. In the case of an annual report, the income statement will display activity from Jan. 1 – Dec. 31, and the balance sheet will display values as of Dec. 31. (Unless of course the company doesn’t use the regular calendar for their fiscal year – but the concept holds regardless of the dates in question.)

The balance sheet can be a bit confusing, but the key points to remember are that it is a snapshot in time, and that it displays a company’s assets, liabilities, and equity, thereby giving you a better understanding of its overall financial health. Take a look at the vocabulary below for a bit more help decoding some of the line items you may encounter, and If you are interested in learning more, check out our great blog post that goes into detail on the ins and outs of balance sheets.

Sample balance sheet, which is one of the financial statements.
Sample balance sheet.

Current Assets

Either cash, or an asset that is expected to be converted to cash within the next year, generally very liquid assets.

Prepaid Expenses / Assets

Items which you have already paid for but haven’t expensed yet on the income statement. For example, good or services that you have already paid for but haven’t received yet. When you receive them you will take this asset off of the balance sheet and add an expense to the income statement.

Long Term Assets

Assets not expected to be converted to cash in the next twelve months.

Current Liablities

Liabilities that will need to be paid in the next twelve months.

Long Term Liabilities

Liabilities that will not be paid in the next twelve months.

PP&E (Property, Plant & Equipment)

As noted above, PP&E stands for Property, Plant & Equipment. This asset category includes the value of the physical assets the you own over a long term such as machinery, buildings, equipment, and vehicles. When these assets lose value through time, it is known as depreciation, which is a non-cash expense on the income statement.

Intangible Assets

Assets that aren’t physical in nature that you will own over a long time frame, such as patents or intellectual property. When these assets lose value through time, it is known as amortization, which is a non-cash expense on the income statement.

Retained Earnings

The profits that have been accumulated through time. Imagine in year 1 you have $1,000 in profits (net income), at the end of year 1 you will have $1,000 in profit on the income statement and $0 in retained earning on the balance sheet. Then in year 2 if you make $3,000 in profits you will have $3,000 on the income statement, and the original $1,000 will be accounted for in retained earnings on the balance sheet. Come year 3 you will have $4,000 in retained earnings on the balance sheet, and the profit you make in that year will be on the income statement. This account represents a key relationship between the income statement and the balance sheet. In short, retained earnings is where you store the net income which you have accumulated in the past.

The Statement of Cash Flows

The third financial statement is the statement of cash flows. The statement of cash flows has never had the same acclaim as the IS and BS, but it is extremely important. The role of the statement of cash flows is to express the actual cash that comes in and out of a business.

You may be thinking, doesn’t the income statement already do that? The answer is no, for several reasons. For one, the income statement includes transactions that may not actually involve the use of cash, for example when you depreciate an asset the depreciation expense is deducted against revenues when determining profit even though there is no cash lost. Or, you may spend cash on transactions that never hit the income statement. For example, when you buy inventory you spend cash, but that inventory is not expensed until it is sold (this is COGS) – in the meantime it represents another asset on your balance sheet.

Another example would be when you purchase long term assets. If you purchase a massive piece of machinery you probably spent a ton of cash, but the purchase won’t hit the income statement at all. The expense associated with that purchase will hit the income statement slowly over time through the depreciation expense, discussed above. Likewise for intangible assets like patents or intellectual property, which eventually are expensed on the income statement via the amortization expense. Given that these kinds of items can be extremely expensive, one can see how checking the income for changes in cash flows can be a major mistake.

Sample statement of cash flows, one of the financial statements.
Sample statement of cash flows.

If you look at the sample statement of cash flows above you will see a perfect example of the difference between net income (from the income statement) and net cash flows, from the statement of cash flows. As you can see, Year 1 has more net income than Year 2, yet in Year 1 the company actually has a net loss of $25,000 in cash, whereas in year 2, the company has a net gain of $163,000 in cash. Why is that? Two primary reasons. For one, in year one there is a major capital expenditure of $150,000. This represents the purchase of a long term asset, like some expensive machinery. That is $150,000 out the door that isn’t touching the income statement (yet) and therefore is not included in the calculation of net income.

In addition, in Year 2 there is a $50,000 increase in cash due to some new debt, presumably a loan of some sort. This also doesn’t hit the income statement, and can only be see here, on the statement of cash flows. These two differences, plus some nominal differences elsewhere on the statement, lead to the substantial discrepancy in cash flows between these years.

If you are really interested in accounting it is crucial you eventually learn the subtleties of cash flow statement, but if you are just looking for a basic understanding of the financial statements suffice it to say that the statement of cash flows is the go to financial statement for examining your cash flows. If you are depending on the income statement for this than you are making a major rookie mistake. (We will be posting an in-depth discussion of the cash flow statement soon should you wish to learn more.)

A zoomed in picture of a pile of money, symbolic of the cash which is tracked by the statement of cash flows, one of the financial statements.
A big old pile of cash – which you track with the statement of cash flows.

Why is all of this important? Well for one, the last thing a business wants to do is to run out of money. Regardless of how big your profits are, running out of money is bad for business. (Very bad.) In addition, it is important to know where your cash is coming from and where it is going, so you can plan accordingly. The statement of cash flows will show you both how much your cash has changed over a period of time (it uses flow variables like the income statement), and what transactions have affected it.

Quick Tip: A classic topic of discussion in business schools is the challenge of a new business with incredibly high profits that fail because they run out of money. Check out this article from Inc. Magazine for three detailed real world examples. Or, to learn even more about the difference between cash flows and profits, check out this article from Harvard Business School.

Like the income statement, the statement of cash flows ties back to the balance sheet. In this case, the statement of cash flows explains the change in the amount of cash (an asset) on the balance sheet over time. So, if at the end of year 1 the balance sheet had $100,000 in cash, and at the end of year 2 it had $50,000, the statement of cash flows will describe in detail why that number went down.

The actual statement of cash flows is broken into three parts: Operating Activities, Investing Activities, and Financing Activities, described below in turn, along with some other key vocabulary.

Operating Activities

These represent cash flows associated with revenue generation, for example cash received from product sales.

Investing Activities

These represent cash flows associated with the acquisition and sale of assets, for example buying a truck (CapEx) or selling a building.

Capital Expenditures (CapEx)

Capital expenditures represent investments in assets that you will use over a long period of time, for example machinery, equipment, or buildings. The amount of the purchase will hit the statement of cash flows initially, then the expense will gradually hit the income statement through depreciation or amortization. This would be categorized on the statement of cash flows under investing activities.

Financing Activities

These represent cash flows associated raising capital, for example acquiring and paying off loans, fundraising from investors, and paying dividends to shareholders.

Concluding Remarks on the Financial Statements

So, there you have it, the three primary financial statements. By examining these statements you can get a very good understanding of the financial standing of a company, be it yours or someone else’s. The income statement provides a picture of revenues, expenses, and profits, the balance sheet breaks down the asset, liability, and equity accounts, and the statement of cash flows sheds light on the cash coming in and out of the company.

As noted earlier, if you want to take a deeper dive into income statements or balance sheets, we’ve got great articles that do just that – Introduction to the Income Statement and What is a Balance Sheet. (Soon we’ll have an Introduction to the Statement of Cash Flows as well, stay tuned.)

If you want to go really deep, like super deep, into these topics then you should read these materials from the CFA Institute. The CFA Institute is an extremely reputable organization in the world of finance and has many great reference materials, not to mention an incredible charter than you can acquire.

Who are we? Why we are My OC Bookkeeper. The best bookkeeping and business advisory firm in Southern California. Reach out to us today and let’s do great things together!

Final point: for more information on why businesses work with companies like us take a look at the first video below. For some great video content on the financial statements, take a look at the second video below.

Why Do Companies Work with Outside Bookkeeping & CFO Services Companies Like My OC Bookkeeper?

Further Learning on the Financial Statements