What Is Depreciation? Types and Practical Examples

If your organization maintains fixed assets like buildings, vehicles, furniture, or equipment, it’s in your best interest to track their depreciation. So, what is depreciation? If you’ve heard of appreciation–when an asset becomes more valuable as time passes–it’s just the opposite. By definition, it’s the gradual decrease in an asset’s value over time. 

Tracking an asset’s depreciation over time helps organizations avoid overpaying taxes on it and make an educated guess about when it will need to be replaced. In this article, we’ll summarize the different types of depreciation and examples of when to use them. 

The Types of Depreciation

There are a number of benefits for your organization when it comes to tracking depreciation in fixed assets. There are various ways to calculate an item’s depreciation each accounting period, and it’s important to note that these methods are not interchangeable.

Here is a quick rundown of the different types of depreciation and some practical examples of when you would use it. For more details on how to calculate depreciation using each method, check out this comprehensive guide on calculating depreciation with step-by-step instructions. 

1. Straight-Line Depreciation

If your organization is on the smaller side, you may want to opt for the simplest method for tracking asset depreciation, the straight-line method. What is straight-line depreciation and how do you calculate it? In short, this method assumes the same amount of yearly depreciation over the course of an asset’s useful life.

As a practical example consider ABC Organization, which has acquired computers for its employees for $200,000. The computers have a residual value of $80,000. According to the IRS, computers are expected to have a useful life of 5 years. In that case, what is the depreciation expense after two years? Calculate $200,000 - $80,000 to get $120,000, then divide by five years to get $24,000—the amount the computers depreciate per year. After two years of use, the item’s accumulated depreciation is $48,000.

You might also consider using the straight-line method combined with prior year accumulated depreciation. Unlike in the example above, which includes the current year in the calculation, you would only add up the accumulated depreciation up to the end of the previous year.

2. Double Declining Balance Depreciation

What if you have fixed assets that are not expected to depreciate linearly? In that case, you are better off using this depreciation method. The double declining balance method applies higher depreciation expenses in the earlier years of an asset’s useful life. 

In order to determine double declining balance depreciation, you must first calculate the straight-line depreciation. So going back to our previous example, we calculated the current value of ABC Organization’s computers. Now, we take that yearly depreciation ($24,000) and double it in order to deduct $48,000 in accumulated depreciation for the computers’ first year of use, or 24% of the computers’ initial purchase value of $200,000. Each year following the first year, we would deduct an additional 24% from the computers’ declining value until their book value matches their salvage value.

3. Sum of the Year Digits (SYD) Depreciation

Like the double declining balance method, SYD depreciation is also an accelerated method—a calculation that accounts for an asset’s higher value in the earlier years. However, this method follows a different formula.

In the example of ABC Organization, you would first add together the digits of the years the computers are expected to be useful, starting with the highest number first. For five years, that would be 5+4+3+2+1 = 15. For SYD, you also need to know the eventual salvage value of the computers, so let’s assume $20,000. To calculate the depreciation for the first year of use, subtract $20,000 from the purchase price of $200,000 to get $180,000. Next, multiply that number by the year (five for the first year of use, to indicate that it has an expected five years of useful life left) divided by the SYD, which is 15. What is the sum of the year digits (SYD) depreciation for the computers’ first year? If your math is correct, $60,000. 

The second year of the computers’ useful life, you would divide the sum of the years (still 15) by 4, to indicate that they have four years of useful life left, but keep the rest of the equation the same. Continue the process each year with 3, then 2, and finally 1. After that, it’s time to replace the fixed asset. 

4. Units of Production Depreciation

With the Units of Production method, an asset’s depreciation is calculated by its output rather than the time passed. It’s an especially popular method to use for equipment and machinery assets, where the asset’s value is far better tied to its volume of production than the years it is in use. 

For example, let’s assume that among a company’s fixed assets is a bookbinding machine that can produce 3,000 books per week or about 150,000 books per year. It is expected to produce a total of 750,000 books before it wears out. It cost $18,000 to purchase and has a salvage value of $8,000. To calculate its depreciation using the units of production method, subtract the salvage value from the initial cost ($10,000), then divide by 750,000. Finally, multiply by the total units it actually produced during the accounting period (let’s say 150,000 for the fiscal year). The units of production depreciation for this accounting period would be $2,000. 

For each accounting period, the equation would stay the same except for the total number of units produced. Many modern machinery and equipment assets automatically track their units of production, which makes this method convenient for organizations with factory assets. 

5. Modified Accelerated Cost Recovery System (MACRS) Depreciation

The Modified Accelerated Cost Recovery System is the standard depreciation method used in the United States for tax reasons. It allows organizations to recover the initial purchase cost of certain depreciable assets over time, making it a good fit for companies looking to reduce taxable income by tracking the gradual wear and tear of their fixed assets. 

The first step to calculating MACRS depreciation is to determine the asset’s expected useful life according to IRS guidelines. Here are some examples from the IRS website based on asset type:

• Three-year useful life: Tractors, manufacturing tools, and some livestock.
• Five-year useful life: Computers, office equipment, cars, light trucks, and construction equipment. 
• Seven-year useful life: Office furniture, appliances, and uncategorized property. 

Let’s calculate ABC Organization’s computers’ depreciation by MACRS. First, we check which percentage to use for 5-year assets in Appendix A of the IRS’s asset depreciation guidelines. In their second year of useful life, the percentage is 38%. So, what is the MACRS depreciation? Multiply the asset’s cost ($200,000) by the percentage for the second year to get $76,000. It’s obvious that this is the highest percentage of depreciation deduction out of all of the examples, which is why it is the primary method for depreciation in tax statements in the United States.

6. Bonus Depreciation

Finally, if your organization has brand new fixed assets that were purchased within this calendar year, don’t forget about the bonus depreciation, or an IRS allowance for business taxpayers to deduct additional depreciation for an asset’s first year of useful life only. To claim this allowance, an asset must have a useful life of less than 20 years. That means a vehicle or computer would qualify, but not a building. 

How To Easily Track Depreciation

If your organization manages numerous kinds of fixed assets, it’s in your best interest to choose the appropriate method for calculating each item’s depreciation. That can get complicated fast, especially if you’re trying to keep it all straight in an Excel spreadsheet. But with a comprehensive platform like Asset Panda, you can streamline your fixed asset management and depreciation tracking in one centralized place.

Asset Panda’s robust platform can be easily customized to track and manage all the assets your organization relies on. Beyond providing real-time visibility into your asset inventory, Asset Panda can track depreciation using various methods and even automate these calculations on a set schedule. With our fixed asset and depreciation tracking solution, your organization can save time, improve data accuracy, and enhance tax compliance. 

Ready to streamline your depreciation tracking?  Discover how Asset Panda can meet your unique needs and request your personalized demo today.