What Are the Different Methods for Calculating Depreciation?
Depreciation methodically accounts for decreases in the value of a company’s assets over time. In the United States, accountants must adhere to generally accepted accounting principles (GAAP) in calculating and reporting depreciation on 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.
- Depreciation accounts for decreases in the value of a company’s assets over time.
- Accountants must adhere to generally accepted accounting principles (GAAP) for depreciation.
- There are four methods for depreciation allowable under GAAP, including straight line, declining balance, sum-of-the-years' digits, and units of production.
How the Different Methods of Depreciation Work
There are four methods for depreciation: straight line, declining balance, sum-of-the-years' digits, and units of production.
To use the straight-line method, the asset's useful life (typically in years) and the salvage value (scrap value) at the end of its life must be estimated. The salvage value is then subtracted from the original cost. The amount remaining, the depreciable cost, is the total amount of depreciation that must be expensed in equal amounts over the asset's estimated useful life."
Declining Balance Depreciation
The declining balance method is a type of accelerated depreciation used to write off depreciation costs more quickly and minimize tax exposure. With the declining balance method, fixed assets depreciate at an accelerated rate rather than evenly over the asset's estimated useful life.
This method is often used if an asset is expected to have greater utility in its earlier years. This method also helps to create a larger realized gain when the asset is actually sold. Some companies may also use the double-declining balance method, which is an even more aggressive depreciation method for early expense management.
Sum-of-the-Years' Digits Depreciation
The sum-of-the-years' digits method offers a depreciation rate that accelerates more than the straight-line method but less than the declining balance method. Annual depreciation is separated into fractions using the number of years of the business asset's useful life. Such assets may include buildings, machinery, furniture, equipment, vehicles, and electronics.
Sometimes called the “SYD” method, this approach is also more appropriate than the straight-line depreciation model if an asset depreciates more quickly or has greater production capacity during its earlier years.
Units of Production Depreciation
Units of production assigns an equal expense rate to each unit produced, which makes it most useful for assembly or production lines. The formula involves using historical costs (the price of an asset based on its nominal or original cost when acquired by the company) and estimated salvage values. The method then determines the expense for the accounting period multiplied by the number of units produced.
Companies have several different options for depreciating the value of an asset over time, in accordance with GAAP. Most companies use a standard depreciation methodology for all of the company’s assets. Thus, depreciation methodologies are typically industry-specific.