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5 Depreciation Methods Business Owners Need to Know

5 Depreciation Methods Business Owners Need to Know

Depreciation of assets is an integral part of a company’s tax strategy which lowers the amount of earnings taxes are based on. This in turn reduces the amount of taxes owed.

Generally Accepted Accounting Principles (GAAP) give business owners the choice of 5 different methods of depreciation to use:

  1. Straight Line
  2. Declining Balance
  3. Double Declining Balance
  4. Sum of the Years' Digits
  5. Units of Production

Each method calculates the rate of depreciation differently and some are better fits for different types of companies.

Some businesses choose one method for depreciating all their assets while some use two or more methods. The reason for using different methods could depend on the useful life of the asset or the company wanting larger deductions early.

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Methods of Depreciation

Before we look at each method more closely, let’s review the terms used in the formulas and what they mean.

Original Cost of the Asset

This is the initial cost that was paid for the asset.

Salvage Value

The estimated salvage price a business believes it would be able to get for the asset by selling it at the end of its useful life.

Useful Life of the Asset

The expected amount of time the asset will be of use to the company.

Current Book Value

The net value of an asset at the beginning of an accounting period. This is calculated by taking the cost of the asset and subtracting the accumulated depreciation.

Depreciation Rate

The rate (as a percentage) at which an asset is depreciated over its estimated lifespan. (Formula = 1/Useful Life of the Asset)

Remaining Lifespan

An estimate (in years) of an asset’s usefulness.

SYD (Sum of the Years' Digits)

The sum of the digits of an asset’s expected life. For example, if an asset is expected to last for 4 years, the SYD would be 10 (4 + 3 + 2 + 1 = 10).

Estimated Units Over Asset’s Lifetime

Number of units an asset is expected to produce during its lifetime.

Actual Units Made

Number of units the asset produced during the current year.

Straight Line Method

This is the simplest and most used depreciation method. It is best for smaller businesses that are looking for a simple way to calculate depreciation.

With the straight line method, you are calculating a depreciation amount that is the same year after year for the life of the asset. This is what makes it the simplest method to use.

Straight Line Depreciation Formula:

(Original Cost of the Asset - Salvage Value) / Estimated Useful Life of the Asset

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Declining Balance Method

This method is best suited for companies that have assets that lose value faster in the early years. Technology (such as computers and cell phones) is an example of an asset that becomes obsolete quickly. The declining balance method provides larger deductions sooner, minimizing tax exposure. It is considered a type of accelerated depreciation.

Declining Balance Depreciation Formula:

Current Book Value x Depreciation Rate

Double Declining Balance Method

Also known as the reducing balance method, double declining is another accelerated depreciation method that, as the name implies, depreciates assets twice as fast as the declining balance method. It is another method that is commonly used by businesses.

As with the declining balance method, double declining is best suited for assets that tend to lose much of their value at the beginning of their useful life. Assets that may become obsolete quickly are another good fit for this method.

Double Declining Balance Depreciation Formula:

2 x Depreciation Rate x Current Book Value

Sum of the Years' Digits (SYD) Depreciation

Another accelerated depreciation method, SYD results in larger depreciation amounts early in the life of an asset, but not as aggressively as declining balance. This method is geared towards assets that lose value quickly or produce at a higher capacity during the early years.

Sum of the Years Digits Depreciation Formula:

(Remaining Lifespan / SYD) x (Original Cost of the Asset - Salvage Value)

Units of Production Method

This depreciation method does not use time as a factor in calculating depreciation. It uses the number of units an asset actually produces and the estimate of how much it will produce over its lifetime.

Companies that produce or manufacture goods would find this method useful.

Units of Production Depreciation Formula: 

(Original Cost of the Asset - Salvage Value) / Estimated Units Produced Over Asset's Lifetime x Actual Units Produced

What Assets Cannot Be Depreciated?

There are some assets that business owners cannot depreciate. Here are a few examples:

Land

Even though land is considered a fixed asset, it is never depreciated since its useful life is unlimited. Buildings and some land improvements may qualify for depreciation, but not the land itself.

Accounts Receivable/Inventory

These assets are not depreciable as it is assumed they will turn into cash in a short amount of time, usually within 1 year.

Minimal Useful Life/Low-Cost Assets

Assets that have little useful life and/or are low-cost are considered expenses, so not depreciable.

Don't Forget About Bonus Depreciation!

The Tax Cuts and Jobs Act (TCJA) raised the bonus depreciation deduction from 50% to 100%. It allows companies to deduct a large portion of the purchase price of the asset during the first year it is in service, instead of spreading the deductions out over the asset’s useful life like the methods above. If a company decides to take bonus depreciation, it must be during the first year of the asset’s life, or they can choose to use one of the depreciation methods above.

This percentage applies to assets acquired between 9/27/2017 and 1/1/2023. Here are the planned rates for upcoming years:

Present through 2022 100%
2023 80%
2024 60%
2025 40%
2026 20%

(These rates may change if Congress changes the law.)

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Which Method is Best for Your Company?

Deciding which depreciation method to use will depend on what your assets are used for and how you want to apply depreciation: slow and steady, start quickly, or based on units of production.

If you’re not sure which method is the best fit for your assets, get advice from an accounting professional. They will walk you through the differences and suggest which method(s) you should choose.

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Biz Tip Topic Expert: Jacob Peters

Jacob Peters

Jake is a Principal with SVA Certified Public Accountants. He uses his extensive experience to provide clients with guidance and consulting in areas such as federal and state income tax planning, debt forgiveness, Roth IRA conversions, energy efficiency tax incentives, and multi-state tax compliance.

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