There are different ways you can depreciate an asset. These methods can give you different results at different stages of the use of your business assets. Whichever method you use, be consistent and use the same method for the asset in question. Track the value, method of depreciation, and deductions on a table using excel or a similar tool. Finally, file the chosen method with your return and make sure it complies with IRS rules, and consult a tax expert to avoid errors and make the most of your deductions. For a simpler post on capitalization so this all makes more sense, read here.
Your three data points:
Asset’s cost (how much you spent on buying it)
The GAAP useful life of assets (The IRS Useful Life Table)
The Asset’s salvage value – how much you can salvage or scrap the asset for at the end of its useful life
Method 1: Straight-Line method
Imagine the simple pizza oven.
It costs 8 grand, with a $300 salvage value, and we deduct a flat 20% of the purchase price every year for 5 years.
8000 – 300 = Amount to depreciate of $7700
| Straight Line Method: Pizza Oven Example | |||
| Years | Amount depreciation rate (7700/5) | Accumulated Depreciation | Remaining Depreciation |
| Year 1 | $1540 | $1540 | $6160 |
| Year 2 | $1540 | $3080 | $4620 |
| Year 3 | $1540 | $4620 | $3080 |
| Year 4 | $1540 | $6160 | $1540 |
| Year 5 | $1540 | $7700 | 0 |
Method 2: The Declining Balance Method
Used for assets that depreciate aggressively in the earlier years of their life. You use a fixed percentage rate instead of a fraction that is evenly divided along the useful life. Here’s the equation:
(Net Book Value – Salvage Value) X Percentage Rate
Net book value = Asset’s value at the start of the year. Calculated by deducting the depreciation you’ve accumulated to date from the total cost of the asset.
The final year of any property class (year 3 of a 3 year property, year 15 of a 15-year property, etc) must be the amount that remains between the net book value and the salvage value.
Example: Pizza Oven. Let’s say for this exercise it has a 5 year class life and a declining balance rate of 40%. Our $8000 oven with a salvage value of $300 would depreciate like this:
| Declining Balance Method: Pizza Oven Example | |||||
| Year | Beginning Net Book Value | Depreciation rate | Depreciation expense (one year) | Accumulated depreciation | Ending Net Book Value (amt left to depreciate) |
| 1 | 8000 | 40% | 3200 | 3200 | 4800 |
| 2 | 4800 | 40% | 1920 | 5120 | 2880 |
| 3 | 2880 | 40% | 1152 | 6272 | 1728 |
| 4 | 1728 | 40% | 691.20 | 6963.2 | 1036.80 |
| 5 (FINAL YEAR) | 1036.80 | 40% | 736.80 (1036.80 – $300 salvage value) | 7700 | 300 (Salvage Value) |
Method 3: The Units of Production Method
If your equipment is directly tied to making things, this might be better for you. There is a rate of depreciation that stays the same from year to year, but it is multiplied by how many units of a thing you make. If you determine that a machine should be able to make a certain number of units, then this may be the method to use.
Returning to the pizza oven. Let’s say a pizza oven should be able to make 25,000 pizzas before it needs to be replaced.
You’ll need two equations, the Depreciation per unit and the Depreciation expense.
Depreciation per unit = (Cost – Salvage value) / Total Estimated Production Unit
(8000 – 300) / 25000 = 7700/25000 = 0.308, or 30.8 cents per unit.
Depreciation expense = Depreciation rate per unit x Unit produced in a particular year
Let’s say you make 12,000 pizzas in a year.
0.308 X 12000 = $3696
Wow, so in the first year, the straight line gave you $1540 in depreciation, while the declining balance method gave you $3200 and the Unit of Production method gave you $3696.
See how the method used changes how much money you keep each year?
Let’s go to the final method accepted by the Generally Accepted Accounting Principles (GAAP).
Method 4: The Sum of Years Depreciation Method
It works like the declining balance method, but instead of using a constant percentage like 40% each year, the percentage rate will change from year to year. We are doing this to let an asset depreciate faster in the earlier years, but in later years not quite as fast. It’s called the ‘sum of years’ method because you are adding the digits in the years of a useful asset’s life. You do this to get the bottom number in the fraction that makes up your depreciation rate.
Let me show you, again, with our pizza oven:
Value: 8000.
Salvage value: $300
Depreciable amount: $7700
This time we’ll keep using the $7700 net book value as our first number, multiplied each year by our depreciation rate to get our depreciation expense for each year. The last year is simply the remainder.
| Sum of Years Method: Pizza Oven Example | ||||
| Year | Amt to be Depreciated | Depreciation rate | Depreciation Expense | Math behind deprec. rate (Sum of Years method) 5 + 4 + 3 + 2 +1 = 15 |
| 1 | $7700 | 33.333% | $2541 | 5 / 15 |
| 2 | $5159 | 26.666% | $2052.82 | 4 / 15 |
| 3 | $3106.18 | 20% | $1540 | 3 / 15 |
| 4 | $1566.18 | 13.333% | $1026.64 | 2 / 15 |
| 5 | $539.54 | Remaining Amount | $539.64 | 1 / 15 |
The declining balance method side by side with the sum of years method looks like this
| Comparing Declining Balance Method with Sum of Years Method | ||
| Years | Amount Deducted (Declining Balance Method) | Amount Deducted (Sum of Years Method) |
| 1 | 3200 | $2541 |
| 2 | 1920 | $2052.82 |
| 3 | 1152 | $1540 |
| 4 | 691.20 | $1026.64 |
| 5 | 736.80 | $539.64 |
As you can see, the amounts of deductions you want in later years will influence which method you use, which is why it’s good to meet with a CPA to determine tax strategy for the assets you purchase as well as work with a bookkeeper who can help you know what questions to ask and keep track of your monthly financials.
Here is the year one depreciation of each method side by side:
| Pizza Oven Year One Depreciation Methods Compared | |
| Method | Year 1 depreciation |
| Straight Line | $1540 |
| Declining Balance Method | $3200 |
| Unit of Production Method | $3696 |
| Sum of Years Method | $2541 |
I am not a CPA, but I can work with you and your CPA to make sure that your business has the records you need, when you need them. Schedule a bookkeeping strategy call with me today. Until then, what kind of depreciation methods do you use for different kinds of assets in your business?