Depreciation Meaning

Depreciation is an important accounting and tax calculation used to determine the reduction in the cost of a physical business asset over its useful life. This article will cover depreciation meaning and definition, as well as various depreciation methods and how you can use them for your business.

Highlights/ Key Takeaways

• Certain tangible or physical assets lose value over time. Depreciation is a calculation performed to measure that loss.
• Some assets can depreciate, while others cannot. The IRS website contains a detailed list of business assets that do depreciate.
• Depreciation can be calculated in multiple ways. The best method to use will depend on the type of asset in question.
• Depreciation is an important tax strategy for businesses. Calculating depreciation on a tax return reduces the amount of taxable business earnings, which, in turn, lowers the total amount owed to the IRS.

What Is Depreciation?

Depreciation meaning can be interpreted in two different ways:

• Depreciation is the loss of asset value over time.
• Depreciation is the process in accounting that allows businesses to spread the cost of an asset over its expected lifetime.

Both of these definitions are correct and simply explain the two main aspects of the depreciation concept. 

To calculate depreciation, you need to know how much you could sell an asset for (its salvage value), as well as how much the asset would be worth if it no longer had any use (its residual value). Next, you can record the calculated depreciation as a business expense, thus reducing your taxable income and the corresponding tax liabilities.

“Depreciation is the process in accounting that allows businesses to spread the cost of an asset over its expected lifetime.”

Why Depreciation Matters to Businesses

While calculating depreciation may seem like a complicated process, it is definitely worth putting in the extra time and effort. Using depreciation in accounting can lead to tax savings and help you allocate funds for future asset acquisition.

All in all, calculating depreciation offers the following benefits to businesses:

• Tax savings. According to IRS rules, depreciation is tax-deductible. Higher depreciation expenses help to reduce the net taxable income, thus increasing tax savings.
• Accurate net book value of assets. The value of a physical business asset will tend to decline over time. By taking depreciation into account rather than simply recording the original purchase cost of the asset, you will be able to calculate a more accurate net book value of your assets.
• Recovery of the asset cost. Whenever you acquire a new asset, you will be faced with the upfront purchase cost. The good news is that depreciation allows you to recover the entire cost of the asset over its lifespan. It also means that you will be able to easily replace the asset in the future using the appropriate amount of revenue.

Assets That Depreciate

Aside from land, most types of tangible property can be depreciated, including machinery, vehicles, equipment, furniture, and buildings.

In general, IRS states that to be considered “depreciable,” the property or asset must meet the following criteria:

• You or your business must own the property.
• The property must be used in your business.
• The property must have a determinable useful life.
• The property must be expected to last for more than a year.

Assets That Don’t Depreciate

Any property that does not meet the previously listed criteria can not be depreciated. Some examples of such assets include:

• Assets that do not lose value over time, such as land
• Assets held for investment purposes, - for example, bonds and stocks
• Property for personal use, such as clothing, as well as your personal residence and car
• Property not currently used to produce income - for example, a building that you aren’t actively renting for income
• Collectibles like coins, art, or memorabilia
• Inventory

Depreciation vs. Amortization

All assets fall into one of two categories: tangible or intangible assets.

• Tangible assets are physical assets or property owned by a company. For example, vehicles, cars, or computer equipment are all considered tangible.
• Intangible assets are assets that have monetary value but do not physically exist. For example, a copyright to a song is considered an intangible asset, as it carries revenue potential for the company but cannot be touched.

The concepts of depreciation and amortization go hand-in-hand, measuring the loss of value of business assets over time. However, depreciation applies to tangible assets, while amortization deals with intangible assets instead. 

The depreciation meaning reflects the anticipated deterioration of an asset. In turn, amortization simply spreads the cost of an intangible asset over its useful life. While these two calculations are quite similar, they are not completely the same.

How Do You Know If an Asset Can be Depreciated or Amortized?

Depreciation and amortization are the two main methods of calculating the loss of value of business assets over time. Whether an asset can be depreciated or amortized will depend on the type of asset in question. Remember, eligible tangible assets can be depreciated, while intangible assets can be amortized.

How to Calculate Depreciation?

Businesses can use five different types of depreciation calculation. These include the Straight-Line method, Declining Balance and Double-Declining Balance methods, the Unit of Production method, and, finally, the Sum-of-the-Years’ Digits method.

Straight-Line Depreciation

Straight-Line depreciation is the most basic method of recording the depreciated value. With this method, the same depreciation expense is recorded every year over the entire useful life of the asset until the asset reaches its salvage value.

Depreciation Formula

Depreciation = (Asset Cost - Asset Salvage Value) / Useful Life, where

Useful Life is the estimated number of years of the asset’s useful life.

Example

Suppose a company owns a piece of large industrial equipment worth $140,000. The equipment is expected to serve for 5 years before breaking down. At this time, the asset can be sold at a salvage value of $20,000.

The asset’s Straight-Line Depreciation can be calculated as:

Straight-Line Depreciation = ($140,000 - $20,000) / 5 years = $24,000 / year

Straight-Line Method Pros

• Very easy to use
• Business owners can expense the same amount every accounting period
• Renders relatively few errors

Straight-Line Method Cons

• The useful life of an asset is an estimation - might not be accurate
• Does not factor in the accelerated asset value loss in the short term
• Does not factor in the likelihood that maintenance costs will increase as the asset gets older

Ideal for:

• Calculating depreciation of an asset whose value decreases steadily over time at approximately the same rate
• Calculating depreciation of fixed assets that simply lose value as they age, - for example, furniture and fixtures

Declining Balance

Declining Balance is an accelerated depreciation method. With this method, the asset is depreciated at a straight-line depreciation rate multiplied by its remaining depreciable amount every year. Since an asset’s value is higher initially, the same rate will lead to a greater depreciation amount in earlier years.

Depreciation Formula

Depreciation per Annum = (Net Book Value - Salvage Value) x Depreciation Rate.

Here, Net Book Value equals the cost of a fixed asset minus the accumulated depreciation over the years. Depreciation Rate is the straight-line depreciation expressed as a percentage.

Net Book Value = Asset Cost - Accumulated Depreciation

Depreciation Rate = 1 / Useful Life x 100%

Example

Continuing the previous example, the Straight-Line Depreciation Rate expressed as a percentage will be:

Straight Line Depreciation Rate = 1 / 5 years x 100% = 20% per year

Year 1 Depreciation = ($140,000 - $20,000) x 20% = $24,000

Net Book Value at the End of Year 1 = $140,000 - $24,000 = $116,000

Year 2 Depreciation = ($116,000 - $20,000) x 20% = $19,200

Net Book Value at the End of Year 2 = $140,000 - $24,000 - $19,200 = $96,800

… and so on.

Declining Balance Method Pros

• Relatively simple to understand
• Helps to offset increased repair and maintenance costs as the asset ages
• Recognized and accepted by income tax authorities

Declining Balance Method Cons

• The value of assets cannot be brought down to zero
• Determining a suitable depreciation rate can be difficult

Ideal for:

• Calculating depreciation of assets that quickly lose their value
• Calculating depreciation of assets that require more maintenance and repairs as they get older
• Calculating depreciation of assets that quickly become obsolete

Double-Declining Balance

The Double-Declining Balance (DDB) method is an accelerated depreciation calculation similar to the Declining Balance method. One major difference is that the DDB method doubles the Depreciation Rate used in the Declining Balance method. This means that the DDB depreciation will be much faster than the Declining Balance depreciation.

Depreciation Formula

Depreciation = 2 x Depreciation Rate x Net Book Value at the Beginning of the Period

As with the Declining Balance Depreciation:

Net Book Value = Asset Cost - Accumulated Depreciation

Depreciation Rate = 1 / Useful Life x 100%

Example

We have previously found that the Straight Line Depreciation Rate will be 20% per year for an asset in question. Therefore, the DDB depreciation rate will equal 2 x 20% = 40% per year.

Year 1 Depreciation = $140,000 x 40% = $56,000

Net Book Value at the End of Year 1 = $140,000 - $56,000 = $84,000

Year 2 Depreciation = $84,000 x 40% = $33,600

Net Book Value at the End of Year 2 = $140,000 - $84,000 - $33,600 = $22,400

… and so on.

Double-Declining Balance Method Pros

• Helps to offset increased repair and maintenance costs as the asset ages
• Can maximize tax savings by allowing higher depreciation expenses in earlier years

Double-Declining Balance Method Cons

• Higher depreciation expenses in earlier years lead to lower profits on financial statement of a business
• More complicated to use than the Straight-Line and the Declining Balance methods
• The value of assets cannot be brought down to zero

Ideal for:

• Calculating depreciation of assets that are likely to lose most of their value in the first years of ownership
• Calculating depreciation of assets that quickly become obsolete
• Calculating depreciation of assets that require more maintenance and repairs as they get older

Units of Production

The Units of Production method requires an estimate of the total number of “units” an asset will produce over its useful lifetime. These “units of production” can refer to the number of hours a piece of equipment is in use or something it produces, - for example, the number of pizzas prepared in a pizza oven. 

Next, depreciation expense per year is calculated based on the number of units produced during this year. This means that every year, the depreciation amount will be different.

Depreciation Formula

Depreciation = (Asset Cost - Salvage Value) / # of Units Produced 

Example

A commercial pizza oven was purchased for $3,000 and can be salvaged for $400 at the end of its useful life. Assuming the oven can produce 10,000 pizzas before breaking down, the Units of Production Depreciation calculation will be as follows:

Units of Production Depreciation = ($3,000 - $400) / 10,000 units = $0.26 / pizza

So, if the oven produces 1,500 pizzas in the first year, its depreciation will be:

Year 1 Depreciation = 1,500 pizzas x $0.26 / pizza = $390

Units of Production Method Pros

• Depreciation cost directly tied to the wear and tear of the asset
• Gives a highly accurate picture of the depreciation cost
• Depreciation value accurately matches revenues and expenses

Units of Production Method Cons

• Not allowed for tax purposes
• Requires tracking the use of equipment or asset
• It is not always possible to estimate the number of units an asset can produce during its lifetime

Ideal for:

• Calculating depreciation of equipment with a quantifiable output during its useful life
• Calculating depreciation when an asset’s value is related to the number of units it produces rather than the number of years it is in use

Sum-of-the-Years’ Digits

The Sum-of-the-Years’ Digits (SYD) method is another type of accelerated depreciation calculation. With this method, you would need to combine all the digits of the expected useful life of the asset. 

Depreciation Formula

SYD Depreciation = (Remaining Lifespan / SYD) x Depreciable Base

Here, SYD is the Sum-of-the-Year’s Digits obtained by adding together the digits for each depreciation year. The depreciable base is calculated as the original Asset Cost minus Salvage Value:

Depreciable Base = Asset Cost - Salvage Value

Example

Suppose you purchase an asset for $250, with a salvage value of $35.  The Depreciable Base will be:

Depreciable Base = $250 - $35 = $215

You are expecting an asset to last three years. This means that you would need to add all the numbers from one through three, or 1 + 2 + 3 = 6. 

In this depreciation example, the first-year depreciation will equal 3/6 of the depreciable base, or $107.5. In the second year, the depreciation loss will be 2/6 of the depreciable base or $71.7. Finally, in the third year, the depreciation will equal 1/6 of the depreciable base or $35.8.

SYD Method Pros

• Increased tax savings during the early years of the asset’s life
• Helps to maintain a balance between the depreciation amount and the asset’s maintenance and repair costs

SYD Method Cons

• More complex as compared to other depreciation methods
• High depreciation expenses in earlier years lead to excessively low profits on the business's financial statements

Ideal for:

• Calculating depreciation of an asset that has a greater production capacity in the earlier years of service as compared to later years
• Calculating depreciation of an asset that depreciates more quickly in the first few years of its useful life

Why Do Tangible Assets Depreciate?

Tangible assets are physical assets subject to wear and tear. They typically have a finite useful life, which means that their value depreciates or decreases over time. Depreciation allows for a more accurate representation of the current cost of the tangible assets on the balance sheet. 

It is also worth keeping in mind that tangible assets will require more repairs and maintenance expenses over time. Accelerated depreciation methods can be useful to help offset these costs: repair costs later in the asset’s life are compensated by higher depreciation expenses early on.

“Tangible assets are physical assets subject to wear and tear. They typically have a finite useful life, which means that their value depreciates or decreases over time.”

What Kind of Tax Impact Does Depreciation Have?

Depreciation of tangible assets is an expenditure, - albeit it is a non-cash one. This means that accurately representing depreciation on your tax returns will increase business expenses, thus reducing taxable earnings. This, in turn, will help you receive tax benefits and reduce how much your business owes in taxes.

Is Depreciation an Operating Expense?

Tangible assets are part of normal business operations, which means that the assets’ depreciation is considered an operating expense. In fact, depreciation is one of the few expenses with no outgoing cash flow.

Cash is originally spent when a fixed asset is acquired, meaning that there is no need to spend any extra cash as part of the depreciation process. As a result, depreciation can be considered a non-cash component of operating expenses.

Final Word

To conclude, depreciation meaning in accounting is simply the loss of a tangible asset’s value over its useful life. It is reflected on the business’s balance sheets and can be used to reduce taxable income and, therefore, receive tax savings.