# Depreciation

## What is Depreciation?

**Depreciation **refers to spreading out the original cost of a fixed asset, such as a factory or equipment, over the estimated useful life of this asset. Depreciation reduces the taxpayers taxable income, but not their actual cash balance. It is essentially a method of compensating businesses for the wear and tear, depletion, obsolescence or deterioration of an asset. There are many items that are depreciable; they are tangible assets such as buildings, machinery, furniture, automobiles, etc. When you are talking about intangible items such as copyrights, patents, trademarks, goodwill, etc., the term amortization is more applicable.

At the end of the useful life of this asset(in accounting terms), the asset is said to have a salvage value. This is considered the scrap value or residual value of the asset and will result in a net cash inflow once the asset is sold.

## Types of Depreciation

The tax code allows for a few different calculations to determine the amount of tax deductions as a result of asset depreciation. Straight line, Units of Production, Sum of Years, and Double Declining Balance are all different forms of depreciation that are acceptable.

### Straight Line Depreciation

Straight line depreciation provides an equal distribution of asset depreciation over the useful life of an asset. This is the most popular method for calculating depreciation, primarily due to its ease of use. To calculate the depreciable amount, one would subtract the salvage value of the asset from the acquisition cost of the asset and divide that over the useful life to arrive at a yearly depreciation amount. For example, assume that company XYZ purchased a truck which has a useful life of 4 years and a salvage value of $2500. Also assume that the truck was purchased for $22,500. To calculate the yearly depreciation, you would use the following formula: ($22,500 - $2,500) / 4, or $5,000 per year.### Sum of Years - Digits Depreciation

The sum of years - digits method of depreciation is an accelerated form of depreciating the asset. It takes a greater percentage of the depreciation in the earlier years, rather than spreading it out equally as the straight line method does.First, understand the useful life of the asset. Once that has been determined, you can proceed to calculate the Sum of Years (in digits) method of weighting the yearly depreciation amounts. Here is how it works. Assume that an asset has a depreciable life of 5 years. Assign the number 1 to 5 to each of the years, starting with 5 and moving to 1.

Example:

2008 - 5

2009 - 4

2010 - 3

2011 - 2

2012 - 1

Now, sum up the total of these numbers (5 + 4 + 3 + 2 + 1) = 15. Now, let's look at the entire formula for determining the depreciable amount to get a better understanding how this fits in.

The number we just calculated above is called the Sum of Years Digits in our image below. As you can see in the first formula, there is an easier way to calculate this number using the formula. The second formula below allows us to calculate the total depreciable amount for the year. Notice how it is weighted by the remainder of the useful life. This is how most of the depreciation takes place in the first year and steadily declines until the end of the useful life. For year 1, you would insert 5 for "Remaining Useful Life" and deduct 1 from that number in every subsequent year.