Depreciation is a concept used for tax and accounting purposes that describes the method a company uses to account for the declining value of its assets. The reasoning? An asset acquired one year is unlikely to be worth as much five years later because it often will have worn down, been depleted, or become obsolete.
When a company buys an expensive fixed asset -- such as costly software, new computers, or manufacturing equipment -- the asset will depreciate (i.e. wear down or become obsolete) over time. Rather than record one large expense in the first year, company accountants will typically depreciate the asset and spread out its expense over several years.
While there are many methods to calculate depreciation (we'll get to those), the most basic is the "straight line" method. Under the straight line method, the depreciation of a given asset is evenly divided over its useful lifetime.
The formula for straight line depreciation is:
Straight Line Depreciation = (Cost of the asset - the asset's salvage value) / (years of estimated useful life)
For example, let's say Company XYZ bought a machine that helps them produce widgets. The machine cost $30,000 and is expected to last five years. It's "salvage value" (the amount the machine is worth after five years of use) is $5,000. Putting this into our formula:
Straight Line Depreciation = ($30,000 - $5,000) / 5 years = $2,500 per year
In this case, Company XYZ's widget machine would depreciate by $2,500 per year under the straight line depreciation method. The accountants for the company would record a non-cash expense of $2,500 at the end of each year until the asset's useful life is over (five years in this example).
Notice we called depreciation a "non-cash expense." That's because neither depreciation (or its related concept, amortization) directly affect the cash flow of a company as it is a non-cash expense. The company is not spending actual as a result of an asset's depreciation, but if a company were to be liquidated its assets wouldn't be worth as much.
[See how to analyze depreciation and more in Financial Statement Analysis for Beginners]
Not only does depreciation let companies more accurately track an asset's useful life in value terms, it also lowers a company's expense in a given year (i.e. instead of a $30,000 expense in the first year, the company could post just a $2,500 expense for five years), helping the company's earnings look more stable and profitable to investors.
That said, companies can't just depreciate assets -- and thereby manipulate earnings and thus tax obligation -- however they want. They must follow strict IRS depreciation guidelines that differ depending on the asset and what industry the company operates in.
Several different methods are commonly used to account for depreciation. In addition to the straight line depreciation method shown earlier, other depreciation methods include:
The Double-Declining Balance Depreciation Method
The double-declining method is an accelerated depreciation method that uses twice the straight-line percentage for the first year. The same percentage is then applied to the balance each subsequent year. A brand-new vehicle purchase, for example, loses most of its value in the first year and depreciation slows down over time.
Let's say Company XYZ buys a $30,000 widget machine and uses the double-declining balance method. Under our straight-line example above, the asset declined 20% per year (100% / 5 years), but this method would double that percentage to 40%.
In the first year, we'd multiply $30,000 by 40% to get $12,000 depreciation and a $18,000 remaining book value. In year two, we'd take $18,000 and multiply it by 40% to get $7,200 depreciation and $10,800 remaining book balance ($18,000 - $7,200 = $10,800). We repeat this process for several years until the value is almost all used up (it never reaches zero under this method).
Here's how the first five years would look under this method:
|Double-Declining Balance Method of Depreciation on a $30,000 Asset|
The 150% Declining Balance Depreciation Method
This method of depreciation uses 150% of the straight-line value for the first year (a bit slower than double-declining method's depreciation rate). The same percentage is then applied to the residual balance each subsequent year.
This is calculated almost the same way as double-declining balance, except it's 150% of the straight-line depreciation rate instead of the double-declining balance rate of 200%. If the straight-line depreciation is 20%, then the 150% declining balance rate would be 30% (20% x a factor of 1.5 = 30%).
Let's say we use the same figures from above combined with this method. In the first year, we'd multiply $30,000 by 30% to get $9,000 depreciation and $21,000 in book value ($30,000 - $9,000 = $21,000). Then we'd do it over the next few years until the asset value reaches nearly zero.
The Units of Production Depreciation Method
Some manufacturing companies like to use the "units of production" method of depreciation to calculate the useful life of its equipment. Instead of using time, this method measures an asset's value by the units it's expected to produce over it's lifetime.
For example, let's say Company XYZ's machine is expected to produce 400,000 widgets over its lifetime. If it produces 100,000 widgets, we'd depreciate one-fourth of its value (or 100,000 units / 400,000 units useful life = 25%).
The Modified Accelerated Cost Recovery System (MACRS) Depreciation Method
The MACRS method is the IRS' system that companies must follow for depreciating assets. Unlike the straight-line method, this is an accelerated depreciation method where the asset loses more of its value over the first few years.
Under the MACRS system, a company must first look up how long the IRS says an asset's useful life is. For example, autos, trucks, and computers may be depreciated over five years while tractors may be depreciated over three years (Yes, it's that detailed of a system!).
After you find the IRS' useful life on the asset, you use the IRS' MACRS table to find the rate you must depreciate the asset each year.
Related Topics for Depreciation: