What Is Depreciation?

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bus math Depreciation

Depreciation determines the loss of value of an asset over its useful life.
Depreciation is an accounting method that spreads the cost of an asset over its expected useful life. Businesses record depreciation as a periodic expense on the income statement. Assets lose value as they depreciate over time. There are four main methods used to calculate depreciation: straight-line, units of production, double declining balance and sum of the years' digits.

Types of depreciation

Businesses have some control over how they depreciate their assets over time.
Good small-business accounting software will help you calculate, record and track depreciation, but you'll still need to understand the process in order to make important decisions about how your business will record depreciation.
Here are four common methods of calculating depreciation, along with when it's best to use them

This is the most common and simplest depreciation method.
Formula: (Cost of asset – Scrap value of asset) / Useful life of asset = Depreciation expense
Most often used for: Equipment that loses value steadily over time.
Pros: It spreads the expense evenly over each accounting period. It’s also easy to automate the adjusting entry for straight-line depreciation in most accounting software.
Cons: Determining the useful life of the asset requires guesswork. A miscalculation could result in the asset being overvalued for several years.

Units of production depreciation is based on how many items a piece of equipment can produce.
Formula: (Number of units produced / Life of asset in units) x (Cost of asset – Scrap value of asset) = Depreciation expense
Most often used for: Manufacturing for equipment that is expected to produce a certain number of items before it's no longer useful.
Pros: Easy to calculate. Because it’s tied to the number of items a piece of equipment produces, it creates a more accurate depreciation calculation.
Cons: You have to keep an accurate record of how many items the equipment has produced. Because production will likely vary from month to month, you’ll need to manually enter this depreciation expense into your accounting software every month. The entry can’t be automated, as it can with straight-line depreciation.

Double declining balance depreciation is an accelerated depreciation method. Businesses use accelerated methods when dealing with assets that are more productive in their early years. The double declining balance method is often used for equipment when the units of production method is not used.
Formula: (100% / Life of asset = Depreciation rate) x 2
Most often used for: Vehicles and other assets that lose value quickly. It writes off an asset’s value the quickest.
Pros: Represents the loss of certain assets’ value more accurately than straight-line depreciation.
Cons: The calculations are more complex than the other methods. Usually business owners using accelerated methods will set up a depreciation schedule — a table that shows the depreciation expense for each year of the asset’s life — so they only have to do the calculations once.

For example, an asset with a useful life of five years would have a reciprocal value of 1/5, or 20%. Double the rate, or 40%, is applied to the asset's current book value for depreciation.
Although the rate remains constant, the dollar value will decrease over time because the rate is multiplied by a smaller depreciable base for each period

Sum of the years’ digits depreciation is also an accelerated depreciation method. It doesn’t depreciate an asset quite as quickly as double declining balance depreciation, but it does it quicker than straight-line depreciation.
Formula: (Remaining life of the asset / Sum of the years' digits) x (Cost of asset – Scrap value of asset) = Depreciation expense
Most often used for: Assets that could become obsolete quickly.
Pros: Lets you choose how many years you want to depreciate an asset, based on its useful life. This gives you control over the depreciation expense you record each month.
Cons: The most difficult depreciation method to calculate. If you use it with the wrong type of asset, you can easily overstate or understate your net income in a given accounting period

For example, an asset with a five-year life would have a base of the sum of the digits one through five, or 1 + 2 + 3 + 4 + 5 = 15. In the first depreciation year, 5/15 of the depreciable base would be depreciated.
In the second year, only 4/15 of the depreciable base would be depreciated. This continues until year five depreciates the remaining 1/15 of the base.

Depreciation examples
Let’s say you purchase a piece of equipment for $260,000. You anticipate using the equipment for eight years, and you anticipate the scrap value will be $20,000. The annual and monthly depreciation expenses for the vehicle using the straight-line depreciation method would be:
($260,000 – $20,000) / 8 = $30,000
$30,000 / 12 months = $2,500 per month

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