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Depreciation is the process of deducting the cost of a business asset over a long period of time.  There are four main methods of depreciation: straight line, double declining, sum of the years’ digits, and units of production.  Each method is used for different types of businesses and types of assets.  Depreciation has two main aspects. The first aspect is the decrease in the value of an asset over time. The second aspect is allocating the price you originally paid for an expensive asset over the period of time you use that asset.

The number of years over which an asset is depreciated is determined by the asset’s estimated useful life, or how long the asset can be used. For example, the estimate useful life of a computer is about five years.  There are multiple classes of assets, including commodities and property.  The IRS has specific guidelines about what types of assets can be depreciated for accounting purposes. According to the IRS, to be depreciable, an asset must include the following:
-Be owned by you 
-Be used in your business or to produce income
-Have a determinable useful life
-Be expected to last for more than one year

You cannot depreciate an asset that does not meet the IRS’ requirements, so nothing that does not wear out, become obsolete, or get used up. 

There are multiple methods of depreciation used in accounting. The four main types of depreciation are as followed:

1. Straight-line depreciation
This is the simplest and most straightforward method of depreciation. It splits an asset’s value equally over multiple years, meaning you pay the same amount for every year of the asset’s useful life.  Straight-line depreciation is a good option for small businesses with simple accounting systems or businesses where the business owner prepares and files the tax return.  Business owners can expense the same amount every accounting period.
Depreciation formula: Divide the cost of the asset (minus its salvage value) by the estimated number of years of its useful life. The “salvage value” is the estimated amount of money the item will be worth at the end of its useful life.  Below is what the formula looks like: (Cost of asset – Salvage value of asset) / Useful life of asset = Depreciation expense

2. Double-declining depreciation
This method, also called declining balance depreciation, which allows you to write off more of an asset’s value right after you purchase it, and less as time goes by. This is a good option for businesses that want to recover more of the asset’s value upfront rather than waiting a certain number of years, such as small businesses with a lot of initial costs and requiring extra cash.  The double-declining balance method is advantageous because it can help offset increased maintenance costs as an asset ages; it can also maximize tax deductions by allowing higher depreciation expenses in the early years.
Depreciation formula: 2 x (Single-line depreciation rate) x (Book value at beginning of the year). The “book value” is the asset’s cost minus the amount of depreciation you have already taken.

3. Sum of the years’ digits depreciation
Sum of the years’ digits (SYD) depreciation is similar to the double-declining method in that it is also an accelerated depreciation calculation. Instead of decreasing the book value, SYD calculates a weighted percentage based on the asset’s remaining useful life.  SYD suits businesses that want to recover more value upfront, but with more even distribution than they would otherwise get using the double-declining method. 
Depreciation formula: (Remaining lifespan / SYD) x (Asset cost – Salvage value). You must first calculate the SYD by adding together the digits for each depreciation year. For example, the SYD calculation for five years is 5+4+3+2+1=15. You then divide each year by this sum to calculate that year’s depreciation percentage. To find the percentage for the first year’s depreciation, you would divide the digit of the first year (5) by the SYD total (15), which comes out to 33% (5 / 15 = 33%).

4. Units of production depreciation
This is a simple way to depreciate the value of an asset based on how frequently the asset is used.  “Units of production” can refer to something the equipment makes,  like the number of pies that can be made in an oven, or the number of hours that it’s in use. This method is good for businesses that want to write off equipment with a quantifiable and widely accepted (i.e., based on the manufacturer’s specifications) output during its useful life. 
Depreciation formula: (Asset cost – Salvage value) / Units produced in useful life

Depreciation reduces the taxes your business must pay via deductions by tracking the decrease in the value of your assets. Your business’s depreciation expense reduces the earnings on which your taxes are based, reducing the taxes your business owes the IRS. The larger the depreciation expense, the lower your taxable income.

 

By Jason Torrents