How to calculate depreciation using three methods

How is depreciation calculated? This question has always been of paramount importance to entrepreneurs. The loss in value of assets can be deducted in many different ways and the final depreciation amount depends on the chosen calculation method. In the United States, the Internal Revenue Service (IRS) provides specific guidelines for calculating depreciation, primarily through the Modified Accelerated Cost Recovery System (MACRS).

What purpose does calculating depreciation serve?

Depreciation is an essential accounting practice that reflects the gradual reduction in the value of business assets over time. It allows businesses to systematically allocate the cost of an asset over its useful life while complying with tax regulations.

When calculating taxes, the United States Internal Revenue Code (IRC) and the Internal Revenue Service (IRS) regulate all tax-related depreciation matters. The IRS provides the Table of Class Lives and Recovery Periods, which assigns specific depreciation periods to different asset types. Businesses must follow these guidelines to properly depreciate assets used for commercial purposes.

To better understand the concept of wear and tear, have a look at this article on the basic principles of depreciation, which outlines key aspects of depreciation. To summarize:

• Business assets (e.g., machinery, vehicles, office equipment, and buildings) naturally lose value over time due to wear and tear, obsolescence, or usage.
• Intangible assets (e.g., patents, copyrights, and software) are also subject to depreciation, though they are typically amortized instead.
• The IRS mandates depreciation calculations using the Modified Accelerated Cost Recovery System (MACRS) for most business assets, providing specific recovery periods and depreciation methods.

How is depreciation recorded?

Depreciation is recorded as an expense on the income statement and reduces the book value of the asset on the balance sheet. Over time, the cumulative depreciation is reflected as a contra-asset account called Accumulated Depreciation.

Types of depreciation in the U.S.

There are three primary depreciation methods used in the U.S.:

1. Straight-Line Depreciation (SLD): Spreads the asset’s cost evenly over its useful life.
2. Declining Balance Method (DBD): Accelerates depreciation by applying a fixed percentage to the remaining book value each year (e.g., Double Declining Balance - DDB).
3. Units of Production Method (UPD): Bases depreciation on asset usage, such as machine hours or miles driven.

Among these, MACRS is the standard method for tax purposes in the U.S., utilizing an accelerated depreciation approach. While businesses may use straight-line depreciation for financial reporting, they often opt for MACRS to maximize tax deductions.

How to calculate depreciation with examples and tips

To calculate depreciation accurately, you need to know:

• The asset’s purchase date
• The asset’s acquisition cost
• The asset’s estimated useful life (expressed in financial years)

Straight-Line Depreciation (SLD) calculation

Straight-line depreciation spreads an asset’s cost evenly over its useful life. The IRS assigns useful life classifications under MACRS for tax purposes. However, businesses may choose straight-line depreciation for financial reporting (GAAP compliance).

Annual Depreciation Expense = (Acquisition Cost - Salvage Value) / Useful Life (in years)

Example: Depreciating a laptop purchase

Let’s assume you purchase a business laptop in June for a net value of $900.

• According to IRS MACRS rules, computers, laptops, and peripheral equipment fall under the 5-year property class (not 3 years).
• The IRS half-year convention applies, meaning depreciation begins mid-year regardless of purchase month (unless the mid-quarter rule applies).
• However, if using straight-line depreciation for financial accounting, the useful life may be set at 3 years by company policy.

Using straight-line depreciation (for financial reporting):

Annual Depreciation Expense = 900 / 3 = 300

First year (prorated):

Since the laptop was bought in June, depreciation is calculated for 7 out of 12 months:

First-Year Depreciation = 300 × (7 / 12) = 175

Second & third year:

The full $300 depreciation applies each year.

Fourth year:

Any remaining balance:

$900 - $175 - $300 - $300 = $125

At this point, the laptop is fully depreciated for accounting purposes.

How to calculate units of production depreciation

The units of production method is a depreciation technique used for assets whose wear and tear depends on usage rather than time. Unlike straight-line or declining balance depreciation, this method records actual asset consumption, making it ideal for assets with variable production rates.

• Depreciation is based on the asset’s total estimated usage (e.g., miles driven, units produced, machine hours).
• The deducted depreciation values are not time-related but rather calculated based on actual performance.
• This method is typically used for manufacturing equipment, vehicles, and machinery where wear and tear is usage-dependent.

Example: Depreciating a truck using units of production

Let’s assume you purchase a truck for $120,000 with an estimated useful life of 300,000 miles.

Step 1: Calculate depreciation per mile

Depreciation per mile = Cost of asset / Total estimated miles

Depreciation per mile = $120,000 / 300,000 mi = $0.40 per mile

Step 2: Calculate first-year depreciation (30,000 miles driven)

First-year depreciation = Miles driven × depreciation per mile

First-year depreciation = 30,000 mi × $0.40 = $12,000

Following years:

• Depreciation is calculated based on actual miles driven per year.
• The process continues until the total mileage limit (300,000 miles) is reached.

Declining balance method of depreciation

The Declining Balance Method is an accelerated depreciation method that applies a fixed percentage to the book value of an asset at the beginning of each year. This results in higher depreciation expenses in the early years of the asset’s life and smaller depreciation amounts in later years.

The key characteristics include:

• More depreciation upfront: Higher expenses in the initial years, which is useful for assets that lose value quickly.
• Based on a constant percentage: The depreciation is always calculated as a percentage of the remaining book value, not the original cost.
• Commonly used in U.S. tax depreciation (MACRS): The IRS Modified Accelerated Cost Recovery System (MACRS) uses a 200% or 150% declining balance for most assets.

Formula for declining balance depreciation:

Depreciation Expense = Beginning Book Value × Depreciation Rate

• The depreciation rate is usually a multiple of the straight-line rate (e.g., double declining balance (DDB) = 2 × SLD rate).
• Salvage value is not considered initially, but depreciation stops once the asset reaches its salvage value.

Example: Depreciating machinery using 20% declining balance

Let’s assume your company purchases machinery for $100,000 with an expected useful life of 10 years and uses a 20% declining balance rate.

Each year, depreciation is calculated based on the remaining book value. The asset never fully reaches zero under this method. Businesses often switch to straight-line depreciation in later years when the straight-line amount is greater than the declining balance method.

Imputed costs versus normal depreciation

Imputed costs (also called opportunity costs) are internal estimates used for decision-making but are not recognized under U.S. accounting (GAAP) or tax (IRS) rules. In contrast, depreciation is a regulated expense that allocates an asset’s cost over time and is recorded in financial statements and tax filings. The IRS requires businesses to use MACRS (Modified Accelerated Cost Recovery System) for tax depreciation, while GAAP allows methods like straight-line, declining balance, or units of production for financial reporting. Replacement costs cannot be used for depreciation calculations—only historical acquisition costs are allowed for tax and financial purposes.

Please note the legal notice for this article.