Properly managing fixed asset depreciation is crucial for maintaining accurate financial records and optimizing tax benefits.
But it can also be a challenge for accounting teams.
Depreciation allows businesses to spread the cost of an asset over its useful life, providing a more realistic view of expenses and profits each year. It also helps ensure compliance with tax regulations, potentially lowering taxable income through depreciation deductions.
With the wide variety of depreciation methods available — some for financial reporting and others for tax purposes — you may not be sure which is the right choice for each type of asset.
This post will cover the most common depreciation methods, helping you understand how and when to use each one.
What is depreciation?
Fixed asset depreciation is the process of allocating the cost of a fixed asset over its useful life (the estimated number of periods the asset will be useful to a company).
Depreciation accounts for the fact that assets depreciate over time due to wear and tear, obsolescence, and other factors. It also helps match the expense of using an asset with the revenue it helps to generate.
Most types of fixed assets are subject to depreciation, including machinery, vehicles, and equipment. One notable exception is land, which is not subject to depreciation.
What is a depreciation schedule?
A depreciation schedule is a table or chart that outlines the depreciation expense for each period over the course of an asset’s useful life. This helps businesses predict and track how an asset’s value decreases period over period, ensuring accurate financial reporting.
Depreciation schedules typically include:
- Asset cost: The original purchase price of the asset
- Useful life: The estimated time the asset will be useful to the business
- Salvage value: The estimated value of the asset at the end of its useful life
- Depreciation method: The chosen method for calculating the depreciation
- Annual depreciation expense: The amount deducted each year from the asset’s value
Common depreciation methods
Depreciation methods can vary based on the type of asset and how it wears out over time. These are some of the most well-known methods for depreciating assets:
Straight-line depreciation
Straight-line depreciation is the most widely used depreciation method. It applies a consistent reduction in value over the asset’s useful life. This method is best for assets that wear out evenly over time, such as office furniture.
The formula to calculate the depreciation expense of an asset using straight-line depreciation is (asset cost - salvage value) / useful life.
Let’s apply the formula to an example. Say you purchase office furniture for $30,000, its salvage value is $3,000, and the useful life is 7 years. The depreciation expense formula would look like this:
($30,000 - $3,000) / 7 = $3,857.14
The depreciation expense is $3,857.14 per year.
Declining balance depreciation
Declining balance depreciation is an accelerated method that applies larger deductions in the first few years of the asset’s useful life. This method is useful for assets that lose value or become outdated quickly, such as laptops, cell phones, and other technology.
The formula for declining balance depreciation is current book value x depreciation rate. The current book value is the asset’s net value at the start of the accounting period.
Let’s say you purchase a laptop for $2,000 and it depreciates at 30% each year. The formula would look like this:
2,000 x 0.30 = 600
The depreciation is $600 for year one.
At the start of year 2, the current book value of the asset is $1400, so the depreciation formula would be as follows:
1,400 x 0.30 = 420
The depreciation for year two is $420. As the years go on, the current book value of the asset decreases, as does the depreciation.
Double-declining balance depreciation
The double-declining balance method is another accelerated depreciation method. Like the name suggests, it doubles the rate at which the asset is depreciated. This method can be useful for vehicles, electronics, and other assets that lose value quickly.
The formula for double-declining balance depreciation is 2 x [(beginning period book value - salvage value) / useful life].
So, let’s say you purchase a vehicle for $70,000, its salvage value is $5,000, and the useful life is 5 years. Let’s calculate the depreciation for year 1.
2 x [($70,000 - $5,000) / 5] = $26,000
The depreciation for year one is $26,000. As you can see, this method significantly accelerates the rate of depreciation, which can be beneficial for financial planning.
Units of production depreciation
The units of production depreciation method is based on asset usage, like hours used or units produced, rather than time passed. While this method is not as common as the others on this list, it can be useful for machinery or equipment whose wear and tear depends on production levels. This method results in a higher depreciation expense in periods with greater usage.
The formula for depreciation is [(cost – salvage value) / total estimated units] x units produced.
Let’s say you purchase machinery for $100,000, it has a $10,000 salvage value, and the total estimated units over its useful life are 500. In the period you’re calculating, you produced 100 units. The formula would look like this:
[($100,000 - $10,000) / 500] x 100 = 18,000
The depreciation expense for this period is $18,000.
MACRS deprecation
The methods we just went over are used to depreciate your fixed assets on your balance sheet. Additionally, businesses must follow strict depreciation guidelines for tax purposes.
This is where the modified accelerated cost recovery system (MACRS) comes in. The Internal Revenue Service (IRS) requires U.S. businesses to use the MACRS depreciation system for most assets, allowing for greater accelerated depreciation in the early years of an asset’s useful life.
There are two depreciation systems under MACRS:
- The general depreciation system (GDS) uses the declining balance method and is used for most asset classes.
- The alternative depreciation system (ADS) uses the straight-line depreciation method over a longer period compared to GDS. ADS is used for certain asset classes, like tax-exempt use property and property used primarily for farming.
Learn more about how the IRS defines asset classes for GDS and ADS.
How to choose the right depreciation method
Now that you have a better idea of the different depreciation methods, you can make an informed decision on which method is most suitable for your fixed assets.
When choosing a method, first consider the nature of the asset. Does the asset wear down evenly or lose value rapidly? For example, for an asset that quickly loses value, like laptops and cell phones, an accelerated method is best.
Next, consider the financial and tax implications of the different methods. Businesses typically use different deprecation methods for financial reporting and tax reporting.
When it comes to financial reporting, the main goal is to provide an accurate view of a company's financial health and performance. Companies often use the straight-line method since it best reflects the actual wear and tear of the asset. This helps match the asset's expense with the revenue it generates, providing consistency for stakeholders.
In terms of tax reporting, the objective is to comply with tax regulations while optimizing deductions. The IRS often requires that businesses adhere to GDS, which uses the declining balance method, giving businesses larger deductions earlier in the asset’s life. Depreciation for tax reporting often focuses on maximizing tax benefits in the short term, which may differ from the economic reality of the asset’s use.
How software can simplify depreciation
If you're starting to feel a little overwhelmed when you think about creating depreciation schedules for your fixed assets, you’re not alone.
Creating and modifying schedules manually is time consuming and leaves a lot of room for human error. Plus, maintaining different records for financial reporting and tax compliance gets confusing. And if your business has hundreds or thousands of fixed assets to manage, it quickly becomes untenable to do so manually.
This is why fixed asset management software is an ideal alternative to spreadsheets. Software can automate many steps in the process, including creating and modifying depreciation schedules. This reduces manual processes and can save accounting teams hours of work each week.
With the right integrations, fixed asset management software can give you a centralized place to store all your data, making it easier to keep track of reports and access clear audit trails.
Automate depreciation with NetAsset
NetAsset was designed by accountants to eliminate the complexity of managing your fixed asset portfolio. This user-friendly fixed asset management solution helps streamline and optimize your company’s entire fixed asset lifecycle, from inception to tax compliance.
NetAsset saves valuable time by automatically creating depreciation schedules with your chosen method, whether it’s one of the methods discussed here or a custom method for your business. Plus, it’s easy to modify schedules with minimal manual work.
With a NetSuite-native version and a version compatible with any ERP, NetAsset offers solutions for every business.
Discover how NetAsset can transform your fixed asset management processes with a self-guided demo, or get started with a free account.
