Notes

Learn about different methods of depreciation and depreciation expense, including: straight-line and declining methods, as well as the difference between physical depreciation and economic depreciation.
Definition of Depreciation
Almost everything we see around us has a useful life because it is being used up little by little every day or will become outdated as technology changes. Think about the computer you are using. You probably expect it to last only about five years because every time you access it, the components inside it get used up a little bit, and improved technology will eventually make it obsolete. This 'using up' is called depreciation, and that five years is considered the computer's useful life.

The useful life of an item or asset depends upon the type of asset, or its property class, which can be determined through industry experience, personal experience, or by consulting Internal Revenue Service Publication 946, which provides a list of property classes and their useful lives.

A computer depreciates over its useful life of five years.
a computer depreciates over its useful life of five years
The Process of Depreciation
As assets depreciate during their useful life, they lose some of their value. For example, the furniture you bought for $1500 five years ago, may only be worth about $500 today. People have been sitting in the chairs or on the couch, the table has scuff marks, and the fabric on the chairs isn't as bright as it was when you first bought them. No one would pay $1500 for the furniture now. It has lost some of its value.

To compensate for this loss of value caused by depreciation, businesses may write off some of the depreciation of long-lasting assets as an expense every year until the item reaches the end of its useful life. This is called residual value. It's what an item is worth at the end of its lease. For example, if you leased a car for 4 years and decided you wanted to purchase the car, the residual value would be what the car is worth now after the lease has expired and with all of the wear and tear that occurred during the lease. Long-lasting assets are things like machinery, vehicles, office furniture, and other items that are not used up quickly, excluding land. Land can never be depreciated because it does not wear out.

Calculating Depreciation
There are many ways to calculate depreciation, but the three most common methods are:

Straight-line method
Unit-of-production method
Double-declining balance method
To calculate depreciation, you need to know the item's useful life or total possible output, its cost (including taxes, shipping, and preparation/setup expenses), and its residual value. For the unit-of-production method, you will also need to know how many units were produced for the production run.

Straight-Line Depreciation
Straight-line is the simplest depreciation method and involves allocating an even rate of depreciation every year for the life of the asset. You calculate annual straight-line depreciation as follows:

Annual Depreciation Expense = (Asset Cost - Residual Value) / Useful Life of the Asset

Example: ABC Company purchases a truck for $20,000. It has a useful life of 5 years and a residual value of $3,000.

Annual Depreciation Expense = ($20,000 - $3,000) / 5 = $3,400

Thus, ABC Company can take $3,400 in depreciation expense every year for the next five years:


Straight line depreciation chart

Unit-of-Production Depreciation
Unit-of-production depreciation is a two-step process, used to calculate depreciation for assets whose useful life is measured in output capability rather than years. Calculate it as follows:

Step 1: Determine depreciation per unit like this:

Per Unit Depreciation = (Asset Cost - Residual Value) / Useful Life in Units of Production

Step 2: Figure the total depreciation of the units actually produced:

Total Depreciation Expense = Per Unit Depreciation x Units Produced

Example 1
XYZ Company purchases a flyer printing press for $50,000 with a useful life of 200,000 units and a residual value of $5,000. It runs a job of 5,000 flyers.

Step 1: Figure depreciation expense for each flyer produced:

Per Unit Depreciation = ($50,000 - $5,000) / 200,000 = $0.225

Step 2: Determine the total depreciation for all 5,000 flyers:

Total Depreciation Expense = $0.225 * 5,000 flyers = $1,125

Once you have figured out the per unit depreciation, you can apply it to future output runs.

Example 2
The same press runs two more jobs: one of 10,000 flyers and a second one of 1800 flyers.

Job One depreciation expense = $0.225 * 10,000 = $2,250

Job Two depreciation expense = $0.225 * 1800 = $405

Double-Declining Balance Depreciation
Double-declining balance depreciation is a form of depreciation, but only at an accelerated rate. Keep in mind that this does not mean there will be more depreciation than any other type of depreciation over the life of the asset. It simply means that depreciation will occur at a faster rate in the beginning years and slow down towards the end of the life of the asset. The depreciation total is the same for both double-declining depreciation and straight-line depreciation. The difference is just when the depreciation occurs. Let's go over the calculation process.

Step 1: Calculate the percentage of depreciation you could take every year for the duration of the asset's useful life:

100 / useful life in years = annual % of depreciation

Step 2: Double the percentage that you calculated in the first step:

annual % of depreciation * 2 = double depreciation %

Step 3: Multiply the asset's book value by the double depreciation % to get the current year depreciation. In the first year, the book value is the same as its cost.

asset book value * double depreciation % = current year depreciation

Step 4: Subtract the current year depreciation from the book value of the asset. The result will be used as the new book value used to calculate depreciation for the next year.

book value of asset - current year depreciation

Example
ABC Company bought a tractor with a 3 year useful life and a $2,000 residual value for $30,000.

Step 1: 100 / 3 = 33.33% annual depreciation. This is the straight-line depreciation.

Step 2: 33.33% * 2 = 66.66% (double depreciation)

Step 3: $30,000 * 66.66% = $19,998 depreciation

Step 4: $30,000 - $19,998 = $10,002 (new-book value)

Step 5: 66.66% * $10,002 = $6667.33

Repeat steps 3 and 4 until you reach the final year, then subtract the residual value from the remaining book value to get the final year depreciation.

Year Book Value Double Depreciation Percentage Depreciation Expense
1 $30,000 66.66% $19,998
2 $10,0002 66.66% $6,667.33
3 $3,334.67 Subtract Residual Value $1,334.67
Lesson Summary
Depreciation allows a business to write off the loss it experiences through the wearing down of assets. There are many ways of figuring depreciation, but the straight-line method is the simplest and the most popular. Generally, depreciation is calculated using the asset's cost, residual value, and useful life.

Residual value: what an item is worth at the end of its life and lease
Double-declining balance depreciation: depreciation will occur at a faster rate in the beginning years and slow down towards the end of the life of the asset
Learning Outcomes
Enjoy the lesson, then set out to achieve these goals:

Repeat the definition of depreciation
Specify depreciated items that businesses can compensate for through tax write-offs
Determine depreciation by performing calculations
Outline the use of the straight-line depreciation method