When talking about which method of depreciation produces the highest net income, it is vital to understand the methods of depreciation. There are five methods of depreciation: straight-line, units of production, service hours, sum of years-digits and declining balance methods. Depreciation is the loss in value of tangible business assets or property over its useful life, except for land. Reviewing how each method works gives you a better idea about which strategy will ensure the highest net income for your business.
Each method of depreciation may have advantages depending on your circumstances. They are:
- Straight-line: This method states that depreciation expense per year = asset cost – residual value ÷ estimated useful life of the asset in years. This method, which divides the depreciation equally over the life of the property or asset, is the simplest one to calculate.
- Units of production: This method states that depreciation rate per unit = asset cost – residual value ÷ estimated total number of units produced over the useful life of the asset. This method depreciates the asset based on how much you use it.
- Service hours: This method states that depreciation rate per service hour = asset cost – residual value ÷ estimated total number of hours of useful service over the useful life of the asset. As the name implies, this method depreciates the asset based on its hours of useful service.
- Sum of years-digits: This method, also called accelerated depreciation, states that the depreciation expense per year = (asset cost – residual value) × remaining useful life in years ÷ sum of years digits. For this method, depreciation is greater for earlier years than later years.
- Declining balance: This method, also called the double-declining balance method and also an accelerated depreciation strategy, states that book value at the end of a year = asset cost × (1 – depreciation rate)n where n = estimated number of years of useful life of the asset. With this method, depreciation expense declines steadily over the useful life of the asset.
The method of depreciation that produces the highest net income depends on the type of business you own. A manufacturing business that produces a product might well book the highest net income by using the units of production depreciation method, while a service business would do better using the service hours method because that kind of business does not produce units to depreciate. Regardless of which method you use, you won't be able to depreciate more than the value, or cost, of the asset.
So, which method is most profitable comes down to when you want to book the loss – which is what depreciation is, essentially – to gain the greatest tax advantage. For that reason, the depreciation methods that yield the highest net income generally come down to two choices: straight-line and accelerated depreciation. With the first method, you average the depreciation cost over the life of the asset. With the second, you book most of the depreciation (or loss) in the earlier years, hence the name "accelerated depreciation."
Until recently, the Internal Revenue Service allowed just two types of depreciation: the straight-line and declining balance methods. The declining balance is a form of accelerated depreciation that allows businesses to deduct 150 to 200 percent per year compared to what they would have deducted using straight-line depreciation. Even under the declining balance method, you can't deduct more than the cost of the asset; you can just deduct it faster. New IRS rules that went into effect Jan. 1, 2018, allow you to depreciate 100 percent of the cost of the asset as soon as you put it into service, an IRS-accounting way of saying as soon as you start using it. That temporary change stays in effect until Jan. 1, 2023.
There is no best method of depreciation. Which method is best for you depends on your business and financial needs. However, it can be helpful to compare straight-line depreciation and accelerated depreciation. In the end, the depreciation method that gives the highest net income depends on when you want to book the higher income – early on or later. The choice depends on when you need the tax deduction the most.