Depreciation: Definition and Types, With Calculation Examples

What Is Depreciation?

Depreciation is an accounting practice used to spread the cost of a tangible or physical asset, such as a piece of machinery or a fleet of cars, over its useful life. The amount an asset is depreciated in a given period of time is a representation of how much of that asset's value has been used up.

Companies depreciate assets for both tax and accounting purposes. There are several different depreciation methods, including straight-line depreciation and accelerated depreciation.

Depreciation Overview

Machinery and equipment are expensive assets for a company to purchase. Instead of realizing the entire cost of an asset in the year it is purchased, companies can use depreciation to spread out the cost of an asset for accounting purposes over a period of years (equal to the asset's useful life). This allows the company to match depreciation expenses to related revenues in the same reporting period—and write off an asset's value over a period of time for tax purposes.

When using depreciation, companies can move the cost of an asset from their balance sheets to their income statements. When a company buys an asset, it records the transaction on its balance sheet as a debit (this increases the asset account on the balance sheet) and a credit; this reduces cash (or increases accounts payable) on its balance sheet. Neither of these entries affects the income statement, where revenues and expenses are reported.

Then, at the end of an accounting period, a company using depreciation will book depreciation for all its capitalized assets that are not yet fully depreciated. These accounting entries will consist of the following:

• Debit to depreciation expense, which flows through to the income statement
• Credit to accumulated depreciation, which is reported on the balance sheet

Depreciation and Taxes

Businesses also use depreciation for tax purposes—namely, to reduce their total taxable income and, thus, reduce their tax liability. Under U.S. tax law, a business can take a deduction for the cost of an asset, thereby reducing their taxable income. But, in most cases, the cost of the asset must be spread out over time; this is called asset depreciation. (In some instances, a business can take the entire deduction in the first year, under Section 179 of the tax code.) The IRS also has requirements for the types of assets that qualify.

Depreciation in Accounting

If an asset is depreciated for financial reporting purposes, it's considered a non-cash charge because it doesn't represent an actual cash outflow. While the entire cash outlay might be paid initially—at the time an asset is purchased—the expense is recorded incrementally (to reflect that an asset provides a benefit to a company over an extended period of time). And, the depreciation charges still reduce a company's earnings, which is helpful for tax purposes.

All U.S. companies are expected to adhere to the generally accepted accounting principles (GAAP)—a set of accounting standards issued by the Financial Accounting Standards Board (FASB)—when using deprecation. Under GAAP, the matching principle (an accrual accounting principle) dictates that expenses must be matched to the same period in which the related revenue is generated; in accounting, depreciation helps to tie the cost of an asset with the benefit of its use over time. The practice of depreciation helps a company capture the incremental expense associated with the using up of an asset every year it is used (and thus, generates revenue).

The total amount depreciated each year, which is represented as a percentage, is called the depreciation rate. For example, if a company has $100,000 in total depreciation over an asset's expected life, and the annual depreciation is $15,000, the depreciation rate would be 15% per year.

Threshold Amounts

Different companies may set their own threshold amounts to determine when to depreciate an asset and when to simply expense it in its first year of service. For example, a small company might set a $500 threshold; any asset purchased for $500 or greater will be depreciated and any asset under $500 will be expensed in the year it is purchased. On the other hand, a larger company might set a $10,000 threshold;

Accumulated Depreciation, Carrying Value, and Salvage Value

Accumulated depreciation is a contra-asset account on a balance sheet; its natural balance is a credit that reduces the overall value of a company's assets. Accumulated depreciation on any given asset is its cumulative depreciation up to a single point in its life.

Carrying value is the net of the asset account and the accumulated depreciation. Salvage value is the carrying value that remains on the balance sheet after which all depreciation is accounted for until the asset is disposed of or sold. Salvage value is what a company expects to receive in exchange for the asset at the end of its useful life.

Types of Depreciation With Calculation Examples

There are a number of methods that accountants can use to depreciate assets. These methods are: straight-line, declining balance, double-declining balance, sum-of-the-years' digits, and unit of production.

Straight-Line Method

The straight-line method is the most basic way to record depreciation. It reports an equal depreciation expense each year throughout the entire useful life of the asset until the asset is depreciated down to its salvage value.

For example, assume that a company buys a machine for $5,000. The company decides that the machine has a useful life of five years and a salvage value of $1,000. Based on these assumptions, the depreciable amount is $4,000 ($5,000 Cost – $1,000 Salvage Value = $4,000 Total Depreciation Amount).

The annual depreciation amount using the straight-line method is calculated by dividing the total depreciable amount by the total number of years of an asset's useful life. In this case, it comes to $800 per year ($4,000 Total Depreciation / 5 Years Useful Life = $800 Annual Depreciation). This results in an annual depreciation rate of 20% ($800 / $4,000).

Declining Balance

The declining balance method is an accelerated depreciation method that begins with the asset's book value instead of its salvage value. Because an asset's carrying value is higher in earlier years (before the appreciation accelerates in later years), the same percentage causes a larger depreciation expense amount in earlier years, then declines each year thereafter. This is the formula:

Declining Balance Depreciation = Book Value x (1 / Useful Life)

Using the straight-line example above, the machine costs $5,000 and has a useful life of five years. In year one, depreciation would be $1,000 ($5,000 x (1 / 5) =$1,000).

In year two it would be ($5,000 - $1,000) x (1 / 5), or $800. In year three, ($5,000 - $1,000 - $800) x (1 / 5), or $640, and so forth.

Double-Declining Balance (DDB)

The double-declining balance (DDB) method is an even more accelerated depreciation method. It doubles the (1 / Useful Life) multiplier, which makes it twice as fast as the declining balance method.

DDB = Book Value x (2 / Useful Life)

Continuing to use our example of a $5,000 machine, depreciation in year one would be $5,000 x (2 / 5), or $2,000. In year two it would be ($5,000 - $2,000) x (2 / 5), or $1,200, and so on.

Note that while salvage value is not used in declining balance calculations, once an asset has been depreciated down to its salvage value, it cannot be further depreciated.

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

The sum-of-the-years' digits (SYD) method also allows for accelerated depreciation. You start by combining all the digits of the expected life of the asset.

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 year, 5/15 of the depreciable base would be depreciated. In the second year, 4/15 of the depreciable base would be depreciated. This continues until year five, when the remaining 1/15 of the base is depreciated. The depreciable base in all of these cases is the purchase price minus the salvage value (or $4,000 in the example above).

For example, year one depreciation would be $1,333 ($4,000 x (5 / 15) = $1,333). In year two, it would be $1,067 ($4,000 x (4 / 15) = $1,067).

Units of Production

This method, which is often used in manufacturing, requires an estimate of the total units an asset will produce over its useful life. Depreciation expense is then calculated per year based on the number of units produced that year. This method also calculates depreciation expenses using the depreciable base: purchase price minus salvage value.

The Bottom Line

Depreciation allows businesses to spread the cost of physical assets over a period of time, which has advantages from both an accounting and tax perspective. Businesses have a variety of depreciation methods to choose from, including straight-line, declining balance, double-declining balance, sum-of-the-years' digits, and unit of production .