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.
The straight-line method determines the estimated salvage value (scrap value) of an asset at the end of its life and then subtracts that value from its original cost. The difference is the value that is lost over time during the asset's productive use. That difference is also the total amount of depreciation that must be expensed.
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, management expenses depreciation at an accelerated rate rather than evenly over a scheduled number of years. This method can be popular if an asset is expected to have greater utility in its earlier years. It 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 methodology 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.
To cite an example, consider an asset with a useful life of five years, which will have a sum-of-the-years value of 15 (5 + 4 + 3 + 2 + 1). The first year is assigned a value of 5, the second year a value of 4 and so on. The depreciation rate for the first year is the straight-line value multiplied by the first year's fraction (5 ÷ 15, or one-third).
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 assign 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, and then determines the expense for the accounting period multiplied by the number of units produced.
The Bottom Line
Overall, companies have several different options for depreciating the value of an asset over time. Most companies use a standard depreciation methodology for all of the company’s assets. Thus, depreciation methodologies are typically industry specific.