Depreciation is a legal accounting term used to calculate the decrease in value of assets and property. It is also a legal way of decreasing taxes you need to pay to the IRS, because you can deduct the depreciated value of the asset from your taxable income. There are three main methods to calculate depreciation: straight line method, declining balance method and sum-of-the-years'-digits method.
Straight Line Method
The straight line method is the simplest and most common depreciation method. With this method, all you do is divide the cost of the asset evenly over its years of life. To calculate depreciation with the straight line method, you need to know how much you paid for the asset. Second, find out the asset's useful life, or how long it will be in use. Third, establish the salvage value for the asset. Salvage value is the value of the asset at the end of its life. To determine this value, you can analyze how much your asset is likely to cost at the end of its life. Once you have this information, divide the difference between the cost of the asset and its salvage value by the asset's span of useful life. The result you obtain is your yearly depreciation.
Declining Balance Method
The declining balance method calculates depreciation in a accelerated manner. Instead of spreading the costs of the asset evenly over its useful life, it calculates a greater depreciation of its cost in its first years of life. Use this method if you want to show more depreciation in the first years. To calculate depreciation with this method, first determine the rate of depreciation. Divide 1 by the asset's useful life and multiply the result by 1.5, or 2 if you prefer the double declining balance method. This result is your depreciation rate. Every year, multiply the book value of the asset -- the cost of the asset minus the accumulated depreciation, which is zero for the first year -- by the depreciation rate. The result is what you deduct from your asset's total cost.
The sum-of-the-years'-digits method is another accelerated method to calculate depreciation. However, the depreciation of the first years is even larger than in the declining balance method. Use this method if it is more convenient for your financial situation to have a larger depreciation for the first few years. To calculate depreciation with this method, find the depreciation fraction, which is the asset's total years of life still left divided by the sum of all the years. For example, if the asset's life is 5 years, divide the years still left by the following sum: 1+2+3+4+5. The general formula for the sum of the year is 1+2+3+4+...+n, where n is the asset's total life. Once you have the value of the fraction for each year, multiply it by the difference between the cost of the asset and its salvage value. The result you get each year is the depreciation for that year.