What Are the Different Ways to Calculate Depreciation?

Depreciation 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.

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.

Declining Balance Depreciation

The declining balance method is a type of accelerated depreciation used 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 is often 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.

Sum-of-the-Years' Digits Depreciation

The sum-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's useful 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.

Units of Production Depreciation

The units of production method assigns an 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 the accounting period multiplied by the number of units produced.

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.