Understanding Depreciation: Every Method Compared With Full Examples

What Depreciation Actually Represents

Depreciation is one of the most misunderstood concepts in introductory accounting. Students often describe it as "the decrease in value of an asset over time." This is not what depreciation is — or at least not what it measures in accounting. Depreciation is the systematic allocation of a long-lived asset's cost over its estimated useful life. It is an accounting process, not a valuation process. A fully depreciated machine on a company's balance sheet may still function perfectly and have significant market value — it simply has a book value of zero or its estimated salvage value.

The purpose of depreciation is to match costs to the periods that benefit from the use of the asset — this is the matching principle, one of the foundational principles of GAAP. When a company buys a machine for $100,000 that will generate revenue for ten years, it would be inappropriate to record the entire $100,000 as an expense in the year of purchase and nothing in the subsequent nine years. Depreciation spreads the cost over the productive life of the asset.

Key Terms Before You Start

Cost — the total amount paid to acquire the asset and bring it to its intended location and condition for use. For a machine, this includes purchase price, freight, installation, and testing costs. Salvage value (also called residual value) — the estimated amount the company expects to receive when the asset is disposed of at the end of its useful life. Depreciable cost — cost minus salvage value; this is the total amount that will be depreciated over the asset's life. Useful life — the estimated period the asset will be used by the company, which may be shorter than its actual physical life.

Method 1: Straight-Line Depreciation

Straight-line depreciation is the simplest and most widely used method. Annual depreciation equals the depreciable cost divided by the useful life in years.

Formula: Annual Depreciation = (Cost − Salvage Value) ÷ Useful Life

Example: A machine costs $50,000, has a $5,000 salvage value, and a 5-year useful life. Annual depreciation = ($50,000 − $5,000) ÷ 5 = $9,000 per year. Each year, the income statement shows $9,000 depreciation expense and the accumulated depreciation account increases by $9,000.

Straight-line is appropriate when the asset provides roughly equal economic benefits throughout its life — office furniture, buildings, and most long-lived assets not subject to heavy use variation.

Method 2: Double-Declining Balance (Accelerated)

The double-declining balance (DDB) method is an accelerated depreciation method that charges higher depreciation in early years and lower amounts in later years. This better matches the pattern of economic benefits for assets that are most productive when new — vehicles, technology equipment, and machinery with high early output.

Formula: Annual Depreciation = Book Value at Start of Year × (2 ÷ Useful Life)

Using the same example: The DDB rate is 2/5 = 40%. Year 1: $50,000 × 40% = $20,000. Year 2: ($50,000 − $20,000) × 40% = $12,000. Year 3: ($30,000 − $12,000) × 40% = $7,200. Note that under DDB, you switch to straight-line in the year when straight-line gives a higher amount — and you never depreciate below salvage value.

Method 3: Units of Production

The units of production method ties depreciation directly to actual use of the asset, making it highly variable from period to period. It is most appropriate for assets whose wear and tear depends on usage rather than time — mining equipment, aircraft, printing presses.

Formula: Depreciation per unit = (Cost − Salvage Value) ÷ Total estimated units of production. Then: Depreciation for the period = Actual units produced × Depreciation per unit.

Example: A machine costs $50,000, has $5,000 salvage value, and is expected to produce 90,000 units over its life. Depreciation per unit = $45,000 ÷ 90,000 = $0.50. If 15,000 units are produced in year one, depreciation = 15,000 × $0.50 = $7,500.

Method 4: Sum-of-the-Years-Digits

Sum-of-the-years-digits (SYD) is another accelerated method. It applies a declining fraction to the depreciable cost each year. The denominator is the sum of the digits from 1 to n (the useful life in years). For a 5-year asset, the sum = 1 + 2 + 3 + 4 + 5 = 15. Year 1 fraction = 5/15. Year 2 = 4/15. Year 3 = 3/15. And so on.

Using the same example: Depreciable cost = $45,000. Year 1: $45,000 × 5/15 = $15,000. Year 2: $45,000 × 4/15 = $12,000. Year 3: $45,000 × 3/15 = $9,000.

Asset Disposal

When an asset is sold or retired, the company must remove the asset and its accumulated depreciation from the balance sheet and recognise any gain or loss. The gain or loss equals the proceeds received minus the asset's book value (cost minus accumulated depreciation).

If proceeds exceed book value, a gain is recognised. If proceeds are less than book value, a loss is recognised. If the asset is scrapped with no proceeds, the full remaining book value is recorded as a loss.

Practise depreciation calculations across all methods with PrepQBank's adaptive practice questions.