Depreciation accounts for decreases in the value of a company’s assets over time. In the United States, accountants must adhere togenerally accepted accounting principles (GAAP)in calculating and reportingdepreciationon financial statements. GAAP is a set of rules that includes the details, complexities, and legalities of business and corporate accounting. GAAP guidelines highlight several separate, allowable methods of depreciation that accounting professionals may use.
Key Takeaways:
- Depreciation accounts for decreases in the value of a company’s assets over time.
- Depreciation allows a business to deduct the cost of an asset over time rather than all at once.
- Accountants adhere to generally accepted accounting principles (GAAP) to calculate depreciation.
- The four methods for calculating depreciation allowable under GAAP include straight-line, declining balance, sum-of-the-years' digits, and units of production.
- The best method for a business depends on size and industry, accounting needs, and types of assets purchased.
Methods of Depreciation
The four depreciation methods include straight-line, declining balance, sum-of-the-years' digits, and units of production.
Straight-Line Depreciation
The straight-line method is the most common and simplest to use. A company estimates an asset's useful life and salvage value (scrap value) at the end of its life. Depreciation determined by this method must be expensed in each year of the asset's estimated lifespan.
Tip
This formula is best for small businesses seeking a simple method of depreciation.
Depreciation: (cost of asset - salvage value)/useful life
Declining Balance Depreciation
Thedeclining balance methodis a type ofaccelerated depreciationused to write off depreciation costs earlier in an asset's life and to minimize tax exposure. With this method, fixed assets depreciate more so early in life rather than evenly over their entire estimated useful life.
This method often is used if an asset is expected to lose greater value or have greater utility in earlier years. It also helps to create a larger realized gain when the asset is sold. Some companies may use the double-declining balance equation for more aggressive depreciation and early expense management.
Tip
This formula is best for companies with assets that lose greater value in the early years and that want larger depreciation deductions sooner.
Depreciation: current book value x depreciation rate
Sum-of-the-Years' Digits Depreciation
Thesum-of-the-years'-digits method (SYD) accelerates depreciation as well but less aggressively than the declining balance method. Annual depreciation is derived using the total of the number of years of the asset'suseful life. The SYD depreciation equation is more appropriate than the straight-line calculation if an asset loses value more quickly, or has a greater production capacity, during its earlier years.
Tip
This formula is best for companies with assets that will lose more value in the early years and that want to capture write-offs that are more evenly distributed than those determined with the declining balance method.
Depreciation: (remaining lifespan/SYD) x (asset cost - salvage value)
Units of Production Depreciation
The units of production method assignsan equal expense rate to each unit produced. It's most useful where an asset's value lies in the number of units it produces or in how much it's used, rather than in its lifespan. The formula determines the expense for theaccounting periodmultiplied by the number of units produced.
Tip
This formula is best for production-focused businesses with asset output that fluctuates due to demand.
Depreciation: (asset cost - salvage value)/estimated units over asset's lifetime x actual units made
Examples
Let's say, ABC company purchases machinery for $25,000. This asset's salvage value is $500 and its useful life is 10 years. The examples below demonstrate how the formula for each depreciation method would work and how the company would benefit.
Calculating Depreciation Using the Straight-Line Method
Formula: (cost of asset - salvage value)/useful life
Method in action: ($25,000 - $500)/10 = $2,450
Result: ABC's yearly tax deduction is $2,450 over the life of the asset.
Calculating Depreciation Using the Declining Balance Method
Formula: current book value x depreciation rate
Method in action: $25,000 x 30% = $7,500
Result: ABC's depreciation amount in the first year is $7,500. In the second year, the current book value would be $17,500 ($25,000 - $7,500). So, the depreciation amount would be $5,250 ($17,500 x 30%). And so on.
Calculating Depreciation Using the Sum-of-the-Years' Digits Method
Formula: (remaining lifespan/SYD) x (asset cost - salvage value) where SYD equals the total of all the years in the lifespan
Method in action: SYD = 55 (1+2+3+4+5+6+7+8+9+10); (10/55) x ($25,000 - $500) = $4,454
Result: in the first year, ABC can deduct $4,454 in depreciation expense. In the second year, the deduction would be $4,009 ((9/55) x $24,500). And so on.
Calculating Depreciation Using the Units of Production Method
Formula: (asset cost - salvage value)/estimated units over asset's life x actual units made
Method in action: ($25,000 - 500)/50,000 x 5,000 = $2,450
Result: ABC's depreciation expense is $2,450 for the year. This method will produce results that vary annually depending on the number of units made.
Special Considerations
Companies have several options for depreciating the value of assets over time, in accordance with GAAP. Most companies use a single depreciation methodology for all of their assets. Thus, the methods used in calculating depreciation are typically industry-specific.
Frequently Asked Questions
What Is Depreciation?
Depreciation is an accounting method that companies use to apportion the cost of capital investments with long lives, such as real estate and machinery. Depreciation reduces the value of these assets on a company's balance sheet.
How Do You Calculate Depreciation Annually?
There are various ways of calculating depreciation. To start, a company must know an asset's cost, useful life, and salvage value. Then, it can calculate depreciation using a method suited to its accounting needs, asset type, asset lifespan, or the number of units produced.
What Does Depreciation Tell You?
Depreciation calculations determine the portion of an asset's cost that can be deducted in a given year. Depending on the method used, the amount may be the same every year. Or, it may be larger in earlier years and decline annually over the life of the asset.
The Bottom Line
There are four allowable methods for calculating depreciation, and which one a company chooses to use depends on that company's specific circ*mstances. Small businesses looking for the easiest approach might choose straight-line depreciation, which simply calculates the projected average yearly depreciation of an asset over its lifespan. Since different assets depreciate in different ways, there are other ways to calculate it. Declining balance depreciation allows companies to take larger deductions during the earlier years of an assets lifespan. Sum-of-the-years' digits depreciation does the same thing but less aggressively. Finally, units of production depreciation takes an entirely different approach by using units produced by an asset to determine the asset's value.
