Depreciation is a calculation used to reduce the value of a fixed asset over a period of multiple years. Many small-business owners find this concept confusing because depreciation does not match cash flow. Instead, it is a calculation made and an entry recorded into the bookkeeping on a recurring basis.

Fixed assets lose their usefulness and value over time. This loss usually doesn’t coincide with when the purchase is made, even if the purchase is made over time by making installment payments. Like accrual basis accounting, depreciation matches expenses to a given time period, but it isn’t strictly an accrual basis concept. This calculation will appear on both cash basis and accrual basis financial statements.

The different depreciation formulas are:

Straight-line depreciation formula:

(Cost of asset – Scrap value of asset) / Useful life of asset = Depreciation expense

Units of production depreciation formula:

(Number of units produced / Life of asset in units) x (Cost of asset – Scrap value of asset) = Depreciation expense

Double declining balance depreciation formula:

100% / Life of asset = Depreciation rate

Sum of the years’ digits depreciation formula:

(Remaining life of the asset / Sum of the years digits) x (Cost of asset – Scrap value of asset) = Depreciation expense

With these formulas in mind, let’s take a closer look at each depreciation method and when you might want to use each.

## Depreciation methods and examples

There are four common methods of depreciation used in accounting. These accounting methods differ from the depreciation schedules used for taxes. They are still important to know in order to determine how to make this calculation from a managerial perspective.

### 1. Straight-line depreciation

The most common method is called straight-line depreciation. It is also the simplest method. With straight-line depreciation, you subtract the estimated salvage or scrap value of the asset at the end of its useful life from the cost of the asset, then divide that value by the useful life of the asset. In other words:

(Cost of asset – Scrap value of asset) / Useful life of asset = Depreciation expense

Example: Let’s say you purchase a piece of equipment for $260,000. You anticipate using the equipment for eight years, and you anticipate the scrap value will be $20,000. The calculation for depreciation of the vehicle under the straight-line method would be:

($260,000 – $20,000) / 8 = $30,000

In order to not skew your end-of-year financial statements, you want to make the depreciation entry each month:

$30,000 / 12 months = $2,500/month

Each month of the year, you would make the following journal entry:

Debit: Depreciation expense $2,500

Credit: Accumulated depreciation: Equipment $2,500

This will reduce your net income by $2,500 each month, and it will also offset the value of the asset on your balance sheet by $2,500 each month.

Note that you’re not crediting the actual asset account on the balance sheet, but a separate account called “accumulated depreciation.” The accumulated depreciation account will have a negative balance, which offsets the value of the asset without changing it on the balance sheet. You will often see these accounts as sub-accounts of the different types of fixed asset accounts on the balance sheet.

### 2. Units of production depreciation

The units of production depreciation method is similar to the straight-line method in that it is simple to calculate. Units of production depreciation is most often used for equipment that is expected to produce a certain number of items before it is no longer useful.

The formula for units of production depreciation is:

(Number of units produced / Life of asset in units) x (Cost of asset – Scrap value of asset) = Depreciation expense

Example: Let’s say the equipment you purchased in the example for straight-line depreciation is a machine you will use to manufacture whatsits. The machine is expected to produce 120,000 whatsits before it is no longer useful. You pay $260,000 for the machine, and the scrap value is estimated to be $20,000.

Each year, you will determine how many units the machine produces. Let’s assume in year one the machine produces 2,000 whatsits, in year two it produces 4,000 and in year three it produces 8,000:

Year 1: (2,000 / 120,000) x ($260,000 – $20,000) = $4,000

Year 2: (4,000 / 120,000) x ($260,000 – $20,000) = $8,000

Year 3: (8,000 / 120,000) x ($260,000 – $20,000) = $16,000

You will continue this calculation yearly until the machine reaches its production capacity of 120,000 whatsits.

As with the straight-line method, you will want to divide the depreciation expense by 12 and record it each month so you don’t skew your financials in the last month of the fiscal year.

### 3. Double declining balance depreciation

Double declining balance depreciation is an accelerated depreciation method. Accelerated methods are used when you are dealing with assets that are more productive in their early years. The double declining balance method is often used for equipment when the units of production method is not used.

The calculations for accelerated methods are a bit more complex than those for straight-line or units of production methods, and so usually business owners using accelerated methods will set up a depreciation schedule — a table that shows the depreciation expense for each year of the asset’s life — so they only have to do the calculations once.

Example: Let’s say you don’t know how many units your whatsit manufacturing machine can produce, but you know it’s likely to last eight years. First, you’ll need to calculate the rate of depreciation:

100% / Life of asset = Depreciation rate

You’ll multiply the depreciation rate above by two because you are doubling the rate of depreciation:

Once you have your depreciation rate, will multiply that rate by the beginning value of the asset to get the depreciation expense for the first year:

Beginning value of asset x Depreciation rate = Depreciation expense

Finally, you need to calculate the value of the asset at the end of year one:

$260,000 (beginning value of asset) – $65,000 (depreciation expense) = $195,000

The depreciation calculation for year two follows the same formula, except now your beginning asset value is $195,000:

And the ending value for year two is calculated:

$195,000 – $48,750 = $146,250

You will continue with these calculations until you reach the scrap value of the asset.

### 4. Sum of the years’ digits depreciation

Like double declining depreciation, sum of the years’ digits depreciation is an accelerated method. The formula is:

(Remaining life of the asset / Sum of the years digits) x (Cost of asset – Scrap value of asset)* = Depreciation expense

*The second part of this equation is the depreciation base

Example: Let’s stick with our whatsit machine for this example. First, let’s calculate our depreciation base:

Cost of asset – Scrap value of asset = Depreciation base

$260,000 – $20,000 = $240,000

Next, you’ll need to determine the “remaining life of the asset/sum of the years’ digits” piece of the calculation. The remaining life is just as it sounds: It’s the remaining life of the asset. For this example, in year one the remaining life will be eight years, in year two it will be seven years, and so on. The tricky bit of this equation is the “sum of the years’ digits” piece.

Here’s how the calculation would look in year one:

8 (remaining life) / (8+7+6+5+4+3+2+1) (sum of the years’ digits) = 0.222

And now you multiply this factor by the depreciation base:

0.222 x $240,000 = $53,280

Our year one depreciation expense is $53,280. In year two, our calculation would look like this:

7 (remaining life) / (8+7+6+5+4+3+2+1) (sum of the years’ digits) = 0.194

0.194 x $240,000 = $46,560

And our year three calculation would be:

6 / (8+7+6+5+4+3+2+1) = 0.167

0.167 x $240,000 = $40,080

You will continue with these calculations until there is no remaining life of the asset and you reach the asset’s scrap value.

### Depreciation for taxes

The four methods above are used for managerial and business valuation purposes. And although it’s important to understand these methods, many small-business owners will only record depreciation as it is calculated by their accountants for the tax return. This ensures the balance sheet matches the tax return, which in turn makes it easier to validate the accuracy of the financial statements.

Tax depreciation is different from depreciation recorded for managerial purposes. Tax depreciation follows a system called MACRS, which stands for modified accelerated cost recovery system. MACRS is a form of accelerated depreciation, and the IRS publishes tables for each type of property. You can learn more about MACRS depreciation and review the tables on the IRS’s website.

## Using depreciation to manage cash requirements

One often-overlooked benefit of properly recognizing depreciation in your financial statements is that you can use this calculation to plan for and manage your business’s cash requirements. This is especially helpful if you want your business to fund the acquisition of future assets rather than taking out a loan to acquire them.

Let’s look back at our very first example. Because we’ve taken the time to determine the useful life of our equipment for depreciation purposes, we can make an educated assumption that the business will need to purchase a new piece of equipment within the next eight years. The earlier we can start planning for that purchase — perhaps by setting aside $2,500 per month in a business savings account — the easier it will be to fund the replacement of the equipment when the time comes.

A version of this article was first published on Fundera, a subsidiary of allstocksnews.com