In the United States, accountants must adhere to generally accepted accounting principles (GAAP) in calculating and reporting depreciation in financial statements. GAAP is a set of rules that encompass the details, complexities, and legalities of business and corporate accounting. GAAP guidelines highlight several separate allowable methods of depreciation that accounting professionals may employ to their practices.
The straight-line method uses the estimated salvage value—aka scrap value—of an asset at the end of its life and then subtracts that value from its original cost. The difference is equal to the value that is lost during the asset's productive use. Once this figure is determined, that number is divided by the management's best-guess estimate of the number of years that the asset will be useful.
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. The most common form of declining balance is the double-declining balance, which is calculated by multiplying the straight-line rate by two. In most cases, the declining balance method applies a higher depreciation charge to the first year of an asset's life and then gradually decreases depreciation expenses for future years.
Sometimes referred to as the “200% declining balance method of depreciation,” this approach is considered to be a common form of accelerated depreciation, where an asset depreciates faster than would be the case under the straight-line method.
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 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.