Understanding the Types of Depreciation Businesses Can Utilize

Depreciation is a crucial aspect of accounting, especially for businesses that own long-term assets such as property, plant, and equipment (PP&E).

It is the process of allocating the cost of an asset over its useful life, with the goal of reflecting the asset’s consumption or wear and tear in the financial statements.

Depreciation allows companies to spread out the cost of their assets and recognize the expense over time instead of recording the entire cost in the year of purchase.

Depreciation is Essential in Accounting for Several Reasons:

1. Depreciation matches the expense of an asset with the revenue it generates, providing a more accurate representation of a company’s profitability.
2. Depreciation helps businesses comply with tax laws by reducing their taxable income.
3. Depreciation is crucial in making informed investment and financing decisions as it allows stakeholders to determine the value of an asset over time.

There are several different depreciation methods, each with its advantages and disadvantages. This eGuide will provide an overview of the most commonly used depreciation methods, along with a comparison to help businesses choose the best method for their needs.

Here is an Extensive List of Terms and Descriptions Used in Depreciation Analysis

Straight-Line Depreciation is the simplest and most widely used method of depreciation. Under this method, the cost of an asset is spread evenly over its useful life.

The Calculation is as Follows:

Annual Depreciation Expense = (Asset Cost - Salvage Value) / Useful Life

The salvage value is the expected resale value of the asset at the end of its useful life. The useful life is the estimated number of years the asset will be used by the company.

Straight-Line Depreciation Example

Suppose that a company purchases a new machine for $10,000. The machine is expected to have a useful life of 5 years and a salvage value of $2,000 at the end of its useful life.

Using the straight-line depreciation method, the annual depreciation expense is calculated as follows:

The annual depreciation expense for this machine is $1,600. This means that the company can deduct $1,600 from its income each year for tax purposes, reflecting the gradual reduction in the machine’s value over time.

The advantages of straight-line depreciation are that it is easy to calculate, provides a steady and predictable expense over the asset’s life, and is less prone to errors or misinterpretations.

However, it may not accurately reflect the actual consumption of the asset as it assumes that the asset’s value decreases at a constant rate.

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The Declining Balance Method is an accelerated depreciation method that allocates a higher depreciation expense to the early years of an asset’s useful life.

The asset’s book value is multiplied by a constant depreciation rate to determine the amount of depreciation expense for each period. The constant depreciation rate is usually twice the straight-line depreciation rate.

The Calculation is as Follows:

Depreciation Expense = Book Value x Depreciation Rate

Declining Balance Depreciation Example

An asset has a cost of $10,000, a useful life of 5 years, and a salvage value of $1,000. The depreciation rate is 40% (twice the straight-line rate of 20%).

Year 1:

Depreciation Expense = $10,000 x 40% = $4,000

Book Value at the End of the Year = $10,000 - $4,000 = $6,000

Year 2:

Depreciation Expense = $6,000 x 40% = $2,400

Book Value at the End of the Year = $6,000 - $2,400 = $3,600

This process continues until the book value reaches the salvage value of the asset, which is the estimated amount that the asset will be worth at the end of its useful life.

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The Double Declining Balance Method is also an accelerated depreciation method that applies a fixed rate of depreciation to the asset’s book value, but at twice the rate of the declining balance method.

This means that the depreciation expense is higher in the early years of the asset’s life and decreases over time.

The Calculation is as Follows:

Depreciation Expense = Book Value x Depreciation Rate x 2

Double Declining Balance Depreciation Example

How to Calculate Depreciation using Double Declining Balance Method (Step-by-Step):

Step 1

Calculate the Straight-Line Depreciation Expense = (Purchase Cost - Salvage Value) / Useful Life Assumption

Step 2

Divide the Annual Depreciation Under the Straight-Line Method by the Purchase Cost of the Fixed Asset (i.e., the "Straight-Line Depreciation Rate")

Step 3

Multiply the Straight-Line Depreciation Rate by 2 (i.e., the "Double Declining Depreciation Rate")

Step 4

Multiply the Beginning of Period Book Value of the Fixed Asset (PP&E) by the Accelerated Rate

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The Sum-of-the-Years’-Digits (SYD) depreciation method is a form of accelerated depreciation. It is typically used when an asset’s useful life is not uniform and is expected to be more productive in its earlier years of use.

This method takes into account the total number of years of an asset’s useful life and allocates more of the depreciation expense to the earlier years of use.

The Calculation is as Follows:

To calculate the depreciation using the SYD method, you must first determine the total number of years in the asset’s useful life.

Next, add up the digits of the useful life years. For example, if an asset has a useful life of 5 years, you would add up the digits 5 + 4 + 3 + 2 + 1, which equals 15.

Each year’s depreciation expense is then calculated by dividing the remaining useful life by the total of the digits and then multiplying that number by the cost of the asset.

Sum-of-the-Years'-Digits Depreciation Example

Suppose you purchase a machine for $10,000 with a useful life of 5 years.

To calculate depreciation for year 1, add up the digits of the useful life:

5 + 4 + 3 + 2 + 1 = 15

The depreciation for year 1 would be calculated as follows:

Year 1 Depreciation = (5/15) x $10,000 = $3,333.33

To calculate the depreciation for Year 2, subtract the prior year's depreciation from the cost of the asset and repeat the calculation using the remaining useful life and the total digits:

Year 2 Depreciation = (4/15) x ($10,000 - $3,333.33) = $1,777.78

The calculation is repeated for each subsequent year until the asset's useful life has been fully depreciated.

Overall, the SYD depreciation method allows for a larger amount of depreciation to be taken in the earlier years of an asset’s useful life, reflecting the higher productivity of the asset during that period.

However, the downside is that the depreciation expense decreases over time, so it may not be as accurate in reflecting the asset’s decreasing value over its useful life. Additionally, this method requires a more complex calculation than the straight-line depreciation method.

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Unit of Production depreciation is a method that applies the cost of an asset to the number of units it produces or the level of activity it generates.

This method is particularly useful for assets whose value is related to their level of production or usage, such as machinery or vehicles.

The Calculation is as Follows:

Annual Depreciation Expense = (Cost of Asset - Salvage Value) / Total Units of Production or Activity Level

The salvage value is the expected resale value of the asset at the end of its useful life.

The total units of production or activity level is the estimated number of units the asset will produce or the level of activity it will generate.

Unit of Production Depreciation Example

Suppose a company purchases a new machine for $100,000. The machine is expected to produce 200,000 units over its useful life of 5 years, and it has a salvage value of $20,000.

In the first year of operation, the machine produces 40,000 units. Using the Unit of Production depreciation method, we can calculate the depreciation expense for the first year as follows:

Therefore, the depreciation expense for the first year is $16,000. This means that the company can deduct $16,000 from its income for tax purposes, reflecting the reduction in the machine’s value based on the number of units it produced during the first year of operation.

The company will repeat this calculation each year, based on the actual number of units produced by the machine in that year.

The advantage of Unit of Production depreciation is that it provides a more accurate reflection of the asset’s consumption, particularly for assets that are used heavily in some years and lightly in others.

This method can also be useful for businesses that want to tie the cost of an asset to its usage or production. However, it can be more challenging to calculate and may not be appropriate for all types of assets.

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MACRS (Modified Accelerated Cost Recovery System) is a tax depreciation method used by businesses in the United States to recover the cost of assets over a specified period of time.

MACRS allows for faster depreciation deductions in the earlier years of an asset’s useful life, which can help businesses reduce their taxable income. The calculation for MACRS depends on the asset’s classification, recovery period, and depreciation method.

There are two depreciation methods allowed under MACRS:

• General Depreciation System (GDS)
• Alternative Depreciation System (ADS)

The GDS method is the more commonly used method and is used to calculate the depreciation for most assets. The ADS method is used for certain types of assets, such as those used outside of the United States.

MACRS Depreciation Example

Suppose a company purchases a piece of equipment for $50,000 on January 1, 2023. The equipment is classified as a 5-year property under MACRS and is placed in service in the first year. The company uses the GDS method to calculate depreciation.

Step 1

Determine the asset’s depreciation method and recovery period.

The asset is a 5-year property, which means it has a recovery period of 5 years.

The asset is depreciated using the GDS method.

Step 2

Determine the applicable depreciation percentage for the asset’s recovery period.

According to the IRS’s MACRS depreciation table, 5-year property has a depreciation percentage of 20% in year 1, 32% in year 2, 19.20% in year 3, 11.52% in year 4, and 11.52% in year 5.

Step 3

Calculate the depreciation expense for each year of the recovery period.

The depreciation expense for the equipment in this example under MACRS GDS for each year of the recovery period is as follows:

• Year 1: $10,000
• Year 2: $12,800
• Year 3: $6,144
• Year 4: $3,345
• Year 5: $3,345

It’s important to note that MACRS calculations can become more complex when dealing with partial years, mid-quarter conventions, or bonus depreciation.

It’s recommended that businesses consult with a tax professional to determine the appropriate depreciation method and calculation for their specific assets.

Depreciation is an important aspect of accounting for businesses that own long-term assets. There are several different methods of depreciation, each with its own advantages and disadvantages.

Here is a comparison of the most commonly used methods of depreciation, along with the factors to consider when choosing a method.

Straight-Line Depreciation

Straight-line depreciation is the simplest method of depreciation. It spreads the cost of an asset evenly over its useful life.

This method is best suited for assets that have a consistent usage pattern and do not experience significant changes in their value over time.

Declining Balance Depreciation

Double Declining Balance Depreciation

Sum-of-the-Years'-Digits (SYD) Method

Unit of Production Depreciation

Modified Accelerated Cost Recovery System (MACRS)

Factors to Consider When Choosing a Method

Nature of the Asset

The type of asset should be considered when selecting a depreciation method. Some assets (such as buildings) have a long useful life and experience minimal changes in value over time, making straight-line depreciation an appropriate method.

Other assets (such as machinery and equipment) may experience higher levels of use and wear and tear in their early years, making accelerated depreciation methods more appropriate.

Expected Useful Life

The expected useful life of an asset is an important factor to consider when choosing a depreciation method.

Straight-line depreciation may be more appropriate for assets with a longer useful life, while accelerated depreciation methods may be more appropriate for assets with a shorter useful life.

Usage or Production

Assets that are tied to usage or production levels may be best suited for the unit of production depreciation method, which allocates the cost of an asset to the number of units it produces or the level of activity it generates.

Tax Implications

Businesses should also consider the tax implications of their depreciation method. For example, MACRS is a depreciation method used for tax purposes in the United States that can result in significant tax savings.

This additional first-year depreciation is available for qualified assets, which include new tangible property with a recovery period of 20 years or less (such as office furniture and equipment), off-the-shelf computer software, and water utility property.

Under the TCJA, through 2026, the definition has been expanded to include used property and qualified film, television, and live theatrical productions. In addition, qualified improvement property is now eligible for bonus depreciation.

For qualified assets placed in service through December 31, 2022, bonus depreciation is 100%. In later years, bonus depreciation is scheduled to be reduced as follows:

For certain properties with longer production periods, these reductions are delayed by one year. For example, 80% bonus depreciation will apply to long-production-period property placed in service in 2024.

The Section 179 expense election is a tax deduction provision of the U.S. Internal Revenue Code that allows businesses to deduct the full cost of qualifying assets in the year they are placed in service rather than depreciating the cost of the asset over its useful life.

This can result in significant tax savings for businesses, especially small businesses, as it reduces their taxable income in the year of purchase.

How to Determine the Section 179 Expense Election

Determine the Cost of the Qualifying Property

This includes the purchase price of the property as well as any other costs associated with acquiring and placing the property into service (i.e., shipping and installation fees).

Check That the Property is Eligible for the Deduction

To be eligible for the Section 179 deduction, the property must be tangible personal property used for business purposes more than 50% of the time. Certain property such as real estate, property used outside of the United States, and property used for lodging do not qualify for the deduction.

Determine the Maximum Amount of the Deduction

The maximum deduction for 2023 is $1,160,000. This means that businesses can deduct up to $1,160,000 of the cost of qualifying property, subject to certain limitations.

Check the Phase-Out Threshold

The deduction is subject to a phase-out threshold, which for 2023 is $2,890,000. This means that if a business purchases more than $2,890,000 in qualifying property, the deduction amount will be reduced by $1 for every $1 over the threshold.

Determine the Taxable Income of the Business

The deduction cannot be greater than the taxable income of the business for the year. If the business has a net loss for the year, the deduction cannot be used to create or increase a net operating loss.

Calculate the Section 179 Deduction

To calculate the deduction, subtract the cost of the qualifying property from the maximum deduction amount, subject to any limitations based on taxable income or the phase-out threshold.

It’s important to note that the Section 179 expense election is a tax provision subject to change. Businesses should consult with a tax professional to determine their eligibility and to ensure they are taking advantage of all available tax incentives.

As you can see there are several different methods of depreciation, each with its own advantages and disadvantages.

Businesses should consider the nature of the asset, expected useful life, usage or production levels, and tax implications when choosing a method.

Choosing the right method is important as it can impact a company’s financial statements, tax liabilities, and investment decisions.

When selecting a depreciation method, businesses should seek the advice of a qualified accountant or tax professional to ensure they choose the method that is appropriate for their specific circumstances.

It is also important to regularly review and adjust depreciation methods as necessary to make sure they accurately reflect changes in the asset’s value and usage over time.

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Which Assets Cannot Be Depreciated?

Land is an example of an asset that cannot be depreciated. Unlike most other assets, land typically does not lose value over time, but instead may appreciate in value. Therefore, it is not subject to depreciation like other tangible assets such as buildings, vehicles, and machinery.

However, any improvements made to the land (such as the construction of a building or installation of utility infrastructure) can be depreciated over their useful lives.

In addition to land, there are several other types of assets that generally cannot be depreciated including:

Goodwill

This is the value of a business that exceeds the value of its individual assets and liabilities. Goodwill is considered an intangible asset and is not subject to depreciation.

Trademarks and Copyrights

These are also intangible assets that cannot be physically worn out or used up over time, so they are not subject to depreciation.

Investments

Assets held for investment purposes (such as stocks and bonds) are not typically depreciated since their value can fluctuate over time and is not directly tied to their physical condition.

Artwork and Collectibles

These assets are not typically used in a business context and are often held for their aesthetic or historical value, so they are not subject to depreciation.

Natural Resources

Assets such as oil reserves, mineral deposits, and timberland are typically subject to depletion rather than depreciation since their value is based on their finite supply rather than wear and tear over time.

Is Depreciation an Operating Expense?

Yes, depreciation is considered an operating expense in accounting. While it does not represent a cash outflow, it is an expense that reflects the decline in value of a company’s tangible assets over time. The cost of an asset is spread out over its useful life and is recognized as an expense in the income statement each year through depreciation.

The amount of depreciation is calculated based on the asset’s original cost, estimated useful life, and estimated salvage value. Depreciation is deducted from revenue to calculate the operating income or earnings before interest and taxes (EBIT) of a business.

Can Building Improvements Be Depreciated?

Yes, building improvements can be depreciated. Building improvements are considered capital expenditures that increase the value or useful life of a building beyond its original condition.

Examples of building improvements that can be depreciated include:

The cost of building improvements is added to the cost basis of the building and then depreciated over the useful life of the improvements, typically over a period of 15 to 39 years depending on the nature of the improvement and the applicable tax regulations.

The depreciation of building improvements is accounted for as an operating expense and is included in the calculation of a company’s net income or earnings.

What is Recoverable Depreciation?

Recoverable depreciation is a term commonly used in the insurance industry and refers to the portion of a claim settlement that has been withheld by the insurer until the repairs or replacement of damaged property are completed.

When an insured property suffers a covered loss, the insurance company will typically calculate the amount of the claim settlement based on the depreciated value of the damaged property. This is known as the actual cash value (ACV) of the property.

Once the insured property is repaired or replaced, the insurance company will issue the recoverable depreciation amount to the insured as an additional payment, up to the amount of the original claim settlement. This is meant to compensate the insured for the difference between the depreciated value of the damaged property at the time of the loss and the cost of repairing or replacing it.

For example, if a homeowner’s insurance policy covers a damaged roof with an ACV of $10,000 and the repair cost is $15,000, the insurer may initially pay out $10,000 and withhold $5,000 in recoverable depreciation. Once the repairs are completed, the insurer would then pay the remaining $5,000 to the homeowner as recoverable depreciation.

What is Accumulated Depreciation?

Accumulated depreciation is the total amount of depreciation that has been charged to an asset since the time it was acquired, up to the balance sheet date.

It is a contra-asset account that reduces the book value or carrying value of the asset on the balance sheet and represents the amount of the asset’s original cost that has been allocated to expense over its useful life.

Each year, the amount of depreciation expense is added to the accumulated depreciation account, which reduces the carrying value of the asset. This process continues until the asset is fully depreciated or disposed of, at which point the accumulated depreciation account will have a balance equal to the total amount of depreciation that has been charged to the asset over its useful life.

Accumulated depreciation is an important accounting concept because it allows a company to accurately reflect the current value of its assets on the balance sheet.

The accumulated depreciation balance provides insight into the age and condition of the company’s assets and is used to calculate the net book value or net carrying value of the assets, which is the amount the assets are worth after accounting for accumulated depreciation.

Is Accumulated Depreciation a Current Asset?

Accumulated depreciation is not considered a current asset. It is a contra-asset account that appears on the balance sheet under the long-term assets section, specifically under property, plant, and equipment.

Accumulated depreciation represents the cumulative depreciation charged to the assets since the time they were acquired, up to the balance sheet date. Current assets are those that are expected to be converted into cash or consumed within one year or the operating cycle of a business, whichever is longer.

Examples of current assets include:

Accumulated depreciation, on the other hand, is a non-cash account that represents the reduction in the book value of long-term assets over their useful lives.

While accumulated depreciation is not a current asset, it is an important account to track for financial reporting purposes as it affects the net book value of long-term assets and the overall financial position of a business.

Is Accumulated Depreciation a Debit or Credit?

In accounting, a credit is used to record increases in liability, equity, and revenue accounts, and decreases in asset, expense, and dividend accounts. Since accumulated depreciation is a contra-asset account that offsets the balance of a related asset account, it has a credit balance.

When an asset is acquired, it is recorded as a debit to the asset account and a credit to cash or another funding source. As the asset is used over its useful life, the cost of the asset is allocated to depreciation expense, which is recorded as a debit to the expense account and a credit to the accumulated depreciation account.

The balance of the accumulated depreciation account represents the total amount of depreciation charged to the asset over its useful life and is subtracted from the original cost of the asset to arrive at the net book value or carrying value of the asset on the balance sheet.

What is Depreciation Recapture?

Depreciation recapture is a tax concept that applies when a business or individual sells a capital asset that has been depreciated for tax purposes.

When a capital asset (such as real estate, equipment, or vehicles) is sold for a price that is greater than its adjusted basis, the difference between the selling price and the adjusted basis is typically subject to capital gains tax.

Depreciation recapture, however, can increase the amount of taxable gain on the sale of a depreciated asset. This occurs when the selling price of the asset is greater than its adjusted basis, and the amount of depreciation taken on the asset exceeds the amount of actual economic depreciation that has occurred.

In this case, the IRS may recapture some or all of the tax benefits of the depreciation that has been claimed over the life of the asset.

The amount of depreciation recapture is generally taxed at a higher rate than other capital gains since it is treated as ordinary income.

The recaptured depreciation is calculated by subtracting the adjusted basis of the asset from the total amount realized on the sale, and then subtracting any remaining undepreciated basis. The resulting amount is treated as ordinary income and is subject to ordinary income tax rates.

Depreciation recapture can occur in various circumstances such as when a business sells its assets or when an individual sells a rental property or a business asset that has been depreciated.

It is important for taxpayers to be aware of the potential for depreciation recapture when selling depreciated assets, as it can have significant tax implications.

Does Depreciation Affect Net Income?

Yes, depreciation affects net income. Depreciation is an expense that is recognized on a company’s income statement each year over the useful life of a tangible asset, thus reducing the net income of the company.

When a company calculates its net income or earnings, it deducts all expenses from total revenue. Depreciation expense is one of the expenses that is deducted from revenue to arrive at the net income amount. Since depreciation expense reduces the amount of taxable income for a business, it also reduces the amount of income tax that the business must pay.

While depreciation does not represent a cash outflow, it is an expense that reflects the decline in value of a company’s tangible assets over time.

The cost of an asset is spread out over its useful life and is recognized as an expense in the income statement each year through depreciation. The amount of depreciation is deducted from revenue to calculate the operating income or earnings before interest and taxes (EBIT) of a business.

The resulting net income figure takes into account all of the company’s expenses (including depreciation) and reflects the true profitability of the business.

Where is Depreciation on Financial Statements?

On the income statement, depreciation is reported as an operating expense and is deducted from revenue to arrive at the company’s operating income or earnings before interest and taxes (EBIT).

This reflects the portion of the asset’s cost that has been allocated to expense over its useful life. On the balance sheet, accumulated depreciation is reported as a contra-asset account under the long-term assets section, typically under property, plant, and equipment. Accumulated depreciation represents the cumulative amount of depreciation that has been charged to the asset since the time it was acquired, up to the balance sheet date.

The accumulated depreciation account reduces the carrying value or book value of the asset and reflects the net value of the asset after accounting for its depreciation over time.

Additionally, the original cost of the asset is reported on the balance sheet under the property, plant, and equipment section, either as a separate line item or as part of a broader category of fixed assets.

The difference between the original cost of the asset and its accumulated depreciation represents the net book value or carrying value of the asset, which is also reported on the balance sheet.

Depreciation of assets is an integral part of a company’s tax strategy. Each business and asset has its own unique circumstances and using an experienced tax advisor who will delve into your specific situation is imperative.

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.