Depreciation Methods, Types and Examples: A Quick Guide

Depreciation methods are essential tools in any business’s financial toolkit. Imagine setting up a new cafe. You have purchased comfortable chairs, bright and cheerful paintings, and the latest coffee machines. These assets lose value due to wear and tear or become outdated.

Here’s where depreciation methods step in. They help calculate the declining value of assets, which affects financial statements and tax calculations.

Worldwide, businesses apply different depreciation methods for various reasons. Some prefer to distribute the cost evenly throughout the asset’s useful life. Others opt for methods that match the asset’s usage or revenue-generation patterns. This diversity in approaches reflects businesses’ unique needs and strategies across industries.

In our dive into depreciation methods, we’ll explore how these techniques impact financial planning and decision-making. For instance, a tech company might favor an accelerated depreciation method for its fast-aging gadgets. It offers a tax advantage in the early years. Conversely, a real estate firm might lean towards a straight-line method, predicting a steady usage pattern over the years.

Understanding depreciation methods involves more than just calculating figures. Making knowledgeable choices that align with your company’s objectives is important.

So, let’s examine the different methods of depreciation.

Table of Content:

1. What is Depreciation?
2. Why Depreciation is So Important?
3. How Does Depreciation Work?
4. Factors For Estimating Depreciation
5. Types of Depreciation Methods
   • Straight-Line Depreciation Method
   • Double Declining Balance Depreciation Method
   • Units of Production Depreciation Method
   • Sum-of-the-Years-Digits Depreciation Method
6. Depreciation Calculations Example
7. How to Analyze Depreciation?
8. Which Depreciation Technique is Best for Your Company?
9. Depreciation Methods FAQs
10. Wrap Up

First…

What is Depreciation?

Definition: Depreciation is the gradual reduction of an asset’s value. It is caused by wear and tear, obsolescence, and usage, among other factors. Depreciation is serious business in accounting and finance, allocating the asset’s value over its useful life.

Various methods are used to calculate depreciation, including:

• The straight-line depreciation method distributes the asset’s cost evenly across its useful life.
• Accelerated depreciation methods, including the declining balance method, load deprival expenses to the early years of an asset’s useful life.

Depreciation is essential for achieving a more accurate representation of a company’s assets. It also helps determine the net income, taxable income, and book value of the company’s assets. Moreover, depreciation is key in making asset replacement, management, and financial planning decisions.

Video Tutorials: How to Visualize Depreciation

How to Visualize Depreciation in Excel?

How to Visualize Depreciation in Google Sheets?

Why Depreciation is So Important?

Depreciation is crucial because it reflects the decline in the value of assets over time, allowing businesses to allocate expenses accurately. This helps in maintaining accurate financial statements, ensures tax compliance, and provides a realistic view of a company’s financial health. By accounting for depreciation, businesses can plan for future replacements or upgrades of assets while also reducing taxable income.

How Does Depreciation Work?

Depreciation allows you to allocate the cost of tangible assets over their useful lives. Understanding how depreciation works is crucial for accurate financial reporting and analysis.

• Initial cost and useful life determination: The process begins with determining the asset’s initial cost, including any acquisition or installation costs. For businesses, this might also involve indirect factors such as customer acquisition expenses when calculating long-term asset value. The useful life of the asset is then estimated, considering factors such as wear and tear, technological advancements, and legal or economic life.
• Choice of depreciation method: There are several depreciation methods available, including straight-line, declining balance, and units of production. The selection of the method depends on factors such as:

• • The nature of the asset
  • The pattern of use
  • Regulatory requirements.

• Calculation of depreciation expense: Once the depreciation method is selected, the depreciation expense is calculated. Each method has its formula. The basic principle is to allocate a portion of the asset’s cost as an expense for each accounting period.
• Recording depreciation expense: Depreciation expense is recorded on the income statement, reducing the net income for the period. This reflects the portion of the asset’s cost used to generate revenue during that period.
• Accumulated depreciation: At the same time, a contra-asset account named “Accumulated Depreciation” is established on the balance sheet. This account accumulates the total depreciation expense recognized over the asset’s life, reducing its carrying value.
• Impact on financial statements:

• • Income Statement: Depreciation expense is reported as an operating expense, reducing the company’s taxable income and net income.
  • Balance Sheet: Accumulated depreciation reduces an asset’s carrying value, impacting metrics such as total assets and shareholders’ equity.

Factors For Estimating Depreciation

1. Asset Cost – Total purchase price, including taxes and installation.
2. Useful Life – Estimated duration the asset remains productive.
3. Residual Value – Expected value at the end of its useful life.
4. Depreciation Method – The chosen method to allocate the cost over time.
5. Asset Usage – The intensity and extent of asset use.
6. Technological Changes – Advancements that may shorten the asset’s life.
7. Maintenance and Wear – The impact of upkeep and natural wear and tear.

Types of Depreciation Methods

What are depreciation methods? The most common depreciation methods include:

1. Straight-line
2. Double declining balance
3. Units of production
4. The sum of years digits

• Straight-Line Depreciation Method

This method is the simplest and most frequently employed, assigning an equal depreciation expense each year throughout the asset’s useful life. The formula for straight-line depreciation is:

• Double Declining Balance Depreciation Method

Also known as accelerated depreciation. This method recognizes higher depreciation expenses in the earlier years of an asset’s life and lower expenses in later years. It calculates depreciation based on a fixed asset’s book value percentage. The formula for double declining balance depreciation is:

Depreciation Expense = Book Value at the beginning of the year × Depreciation Rate.

• Units of Production Depreciation Method

This method bases depreciation on the actual usage or output of the asset rather than the passage of time. Depreciation expense is calculated based on the number of units produced or the hours of operation. The formula for units of production depreciation is:

• Sum-of-the-Years-Digits Depreciation Method

This method accelerates depreciation like the double declining balance method but is less aggressive. It calculates depreciation by multiplying the depreciable base (cost minus salvage value) by a fraction. The numerator is the asset’s remaining useful life, and the denominator is the sum of the years’ digits.

The formula for sum-of-the-years-digits depreciation is:

Depreciation Calculations Example

Example:

A company purchases machinery for $15,000, with an expected useful life of 8 years and a residual value of $3,000.

Step 1: Calculate the Depreciable Value

The depreciable value is the difference between the asset’s purchase cost and its residual value:
Depreciable Value = $15,000 – $3,000 = $12,000

Step 2: Determine the Annual Depreciation

Using the straight-line method, the annual depreciation is determined by dividing the depreciable value by the asset’s useful life:
Annual Depreciation = Depreciable Value ÷ Useful Life
Annual Depreciation = $12,000 ÷ 8 = $1,500

Step 3: Record Depreciation Over 8 Years

Each year, the company will record a depreciation expense of $1,500. After 8 years, the machinery’s book value will decrease to its residual value of $3,000.

How to Analyze Depreciation?

Data analysis can be daunting, especially with depreciation, where numbers dance and dip like a complicated tango. Enter data visualization, the flashlight that illuminates insights hidden in the complexity of depreciation figures. It transforms the abstract into the tangible, making patterns and trends leap off the screen.

But let’s face it: Excel has been the go-to partner for this dance. However, it sometimes steps on your toes. It often leaves us squinting at rows of data, trying to decipher the story they tell.

That’s where ChartExpo pirouettes onto the stage. It’s the solution that elevates data visualization, ensuring Excel’s data analysis performance doesn’t miss a beat.

Let’s learn how to install ChartExpo in Excel.

• Open your Excel application.
• Open the worksheet and click the “Insert” menu.
• You’ll see the “My Apps” option.
• In the Office Add-ins window, click “Store” and search for ChartExpo on my Apps Store.
• Click the “Add” button to install ChartExpo in your Excel.

ChartExpo charts are available both in Google Sheets and Microsoft Excel. Please use the following CTAs to install the tool of your choice and create beautiful visualizations with a few clicks in your favorite tool.

Example

Let’s analyze the depreciation data below using ChartExpo.

Year	Amount
1	25000
2	-5556
3	-4861
4	-4167
5	-3472
6	-2778
7	-2083
8	-1389
9	-694

• To get started with ChartExpo, install ChartExpo in Excel.
• Now Click on My Apps from the INSERT menu.

• Choose ChartExpo from My Apps, then click Insert.

• Once it loads, scroll through the charts list to locate and choose the “Waterfall Chart”. This chart is best suited to this scenario.

• You will see a Waterfall Chart on the screen.

• Click the “Create Chart From Selection” button after selecting the data from the sheet, as shown.

• ChartExpo will generate the visualization below for you.

• First, you can disable the button of last Node (Set as Total) by clicking the small pencil icon as follows:

• If you want to have the chart’s title, click Edit Chart, as shown in the above image.
• Click the pencil icon next to the Chart Header to change the title.
• It will open the properties dialog. Under the Text section, you can add a heading in Line 1 and enable Show.
• Give the appropriate title of your chart and click the Apply button.

• You can change the colors of nodes by clicking the small pencil icon below the legends:

• Click the “Save Changes” button to persist the changes.

• Your Waterfall Chart will appear as below. If you want to export your chart, you can do it so below; we are showing you in SVG form as follows:

• Export the final look of your Waterfall Chart as shown below:

Insights

• The initial amount in the first year is $25,000.
• Years 2-9: Amounts decrease each year.
• In Year 9, a last payment of -$694 was made, showing a decrease in debt or liability as time passed.

Which Depreciation Technique is Best for Your Company?

The best depreciation method for your company depends on your business needs and asset usage. If your assets lose value evenly over time, the Straight-Line Method is ideal for simplicity.

For assets that depreciate faster in the early years, the Declining Balance Method is better for tax benefits. Companies with assets tied to production levels may prefer the Units of Production Method to match depreciation with usage.

Ultimately, choosing the right method aligns with your financial goals and accurately reflects asset value.

Depreciation Methods FAQs

How do I know what depreciation method to use?

Choose a depreciation method based on the following:

• Asset type and usage pattern.
• Desired impact on financial statements.
• Regulatory requirements.
• Available data and ease of calculation.

Consult with accounting professionals for guidance.

Which is better, straight-line depreciation or MACRS?

Determining between straight-line depreciation or MACRS depends on the following:

• Asset type and class life.
• Tax regulations.

MACRS offers accelerated depreciation, whereas straight-line provides even depreciation. Before deciding, consider financial goals and tax implications.

Why use straight-line depreciation instead of MACRS?

Straight-line depreciation may be preferred because:

• It provides simplicity and predictability.
• It is easier to understand and calculate.
• Useful for assets with steady or predictable usage.
• MACRS may not align with business needs or financial reporting requirements.

Wrap Up

Understanding the various types of depreciation methods is crucial for effective asset management and financial reporting. With four primary methods available, businesses have options to match depreciation to their specific needs:

1. Straight-line
2. Double declining balance
3. Units of production
4. Sum-of-the-years digits

Each depreciation method offers distinct advantages and considerations. Straight-line depreciation, for instance, provides simplicity and predictability, making it suitable for assets with steady or predictable usage patterns. Conversely, accelerated methods like double declining balances allow higher depreciation expenses in the early years. They reflect a faster loss of value.

The units of production depreciation method bases depreciation on actual asset usage. This feature renders it beneficial for assets experiencing significant output variations over time. Meanwhile, the sum-of-the-years digits method combines elements of both straight-line and accelerated depreciation. It offers a middle ground between predictability and faster expense recognition.

However, the choice between straight-line depreciation and MACRS (Modified Accelerated Cost Recovery System) depends on various factors. MACRS, being a tax-based depreciation system, may offer accelerated depreciation benefits for tax purposes.

Despite the tax advantages of MACRS, businesses may still opt for straight-line depreciation. Why? For its simplicity and alignment with financial reporting needs. Straight-line depreciation provides a clear and consistent method for allocating asset costs over their useful lives. It ensures transparency and accuracy in financial statements.

Conclusively, to select the most appropriate depreciation method for your assets, you should carefully evaluate:

• Your specific needs
• Regulatory requirements
• Financial goals