What Are Three Methods of Depreciation?

Posted by Clay Schmidt on Sep 15, 2021

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We’re going to review the three most popular depreciation methods. Selecting an efficient depreciation method can result in taxation that better aligns with a company’s ability to generate revenue. Of course, you’ll want to speak with your tax adviser before deciding on any of these methods.

Straight Line

The straight line method is a good option if you know how long an asset will last and what it will be worth at its end of life. It provides a way to take a set amount of depreciation for the life of the asset. This is useful with assets such as vehicles, farm equipment, and heavy machinery that have predictable life use. An equal amount is expensed every year until it reaches the salvage value.

The end of life value is also called the salvage or residual value. The company that the equipment was purchased from will often have a salvage value based on some number of years of use.

To calculate depreciation using the straight line method, the following formula is used:

(cost - salvage value) / (useful life)

However, we’ll build out a depreciation schedule to show how everything fits together. Let’s say we want to depreciate a $200,000 asset over 10 years. Its salvage value will be $25,000. That means we’ll depreciate $175,000 over 10 years. To find the depreciation rate, we use:

Depreciation rate = 1 / 10 = 10%

Annual depreciation = 10% x $175,000 = $17,500

$17,500 is the amount we’ll depreciate each year. These same numbers can be derived using the following formula:

(cost - salvage value) / useful life

($200,000 - $25,000) / 10 = $17,500

The $200,000 purchase price is also called the book value (BV). We’ll use opening and closing book values in a depreciation schedule to show the effect of depreciation on the asset. Because the depreciation amount is the same every year, we won’t list it in the schedule.

Year

Opening BV

Closing BV

Total Depreciation

2010

$200,000

$182,500

$17,500

2011

$182,500

$165,000

$35,000

2012

$165,000

$147,500

$52,500

2013

$147,500

$130,000

$70,000

2014

$130,000

$112,500

$87,500

2015

$112,500

$95,000

$105,000

2016

$95,000

$77,500

$122,500

2017

$77,500

$60,000

$140,000

2018

$60,000

$42,500

$157,500

2019

$42,500

$25,000

$175,000

Some companies may prefer to take higher depreciation right after an asset is purchased. This can help offset some of the initial purchase cost. That’s where the double declining balance method comes in.

Double Declining Balance

Double declining balance is an accelerated depreciation method. Depreciation expense is larger in earlier years and smaller in later years, making it a variable depreciation amount each year. This has the effect of lowering an investor’s tax bill in earlier years since income is also lowered.

The formula for calculating double declining balance is: 

(depreciation rate) x 2 x (beginning period book value)

Let’s build out a depreciation schedule to see it in action. We’ll depreciate a $5,000 asset (a computer) over 5 years. The annual depreciation rate is 1 / 5 = 20%. The depreciation rate multiplied by 2 is a constant. We can compress that part of the value into its constant value, which is 0.20 x 2 = 0.40. And now for the schedule.

Year

Opening BV

Depreciation Exp

Closing BV

Total Depreciation

2010

$5,000

$2,000

$3,000

$2,000

2011

$3,000

$1,200

$1,800

$3,200

2012

$1,800

$720

$1,080

$3,920

2013

$1,080

$432

$648

$4,352

2014

$648

$259

$389

$4,611

Notice that for this method, we didn’t have to use the salvage value in our calculation.

The previous two methods are not tied to the production or output of an asset. For that, the units of production method is used.


Units of Production

Units of production ties depreciation to the output of an asset. Unlike a truck or computer, there’s a direct correlation to the productivity of this asset, which also means depreciation can be tracked based on the production of the asset.

The depreciation expense will vary each year because it depends on the output produced by assets. During years when production increases, there is a large depreciation expense and vice versa.

The formula for units of production is:

(# units produced / # units over lifetime of asset) x (cost - salvage value)

Or

(depreciation per unit) x (number of units produced)

Where: depreciation per unit = (depreciable cost) / (useful units)

Where: depreciable cost = cost - salvage value

Below is an example depreciation schedule over 8 years for a $20,000 asset.

 

Year

Opening BV

No. Of Units

Depreciation Exp

Closing BV

Total Depreciation

2010

$20,000

15000

900

$19,100

$900

2011

$19,100

10000

600

$18,500

$1,500

2012

$18,500

25000

1500

$17,000

$3,000

2013

$17,000

20000

1200

$15,800

$4,200

2014

$15,800

25000

1500

$14,300

$5,700

2015

$14,300

18000

1080

$13,220

$6,780

2016

$13,220

30000

1800

$11,420

$8,580

2017

$11,420

12000

720

$10,700

$9,300

 

Matching a specific depreciation method to a company’s use of assets can result in a more efficient use of annual depreciation. This matters because it also affects the tax bill. 

The straight line method requires knowing the salvage value of an asset and the number of years for useful life. The double line balance method starts with a high depreciation expense each year and continually drops from there. It doesn’t require knowledge about the salvage value of an asset. The units of production method is suited to assets that produce products. It allows management to tie asset output to the amount of annual depreciation expense.


This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation. Examples shown are hypothetical and for illustrative purposes only.

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