Depreciation uses the following terms:
- Cost: the cost to acquire or construct the asset
- Salvage value: the estimated value of the asset is the amount you could realize if you sold, traded-in or scrapped the asset after fulling depreciating it, less any disposal costs
- Recovery period: the useful lifetime of the asset. This is the period that the asset owner plans to use the asset
- Obsolescence: a factor that can shorten an asset’s recovery period. For example, an asset that might have a useful lifetime of 20 years but is expected to be obsolete in seven years will have a GAAP recovery period of seven years. Obsolescence doesn’t affect MACRS depreciation
There are multiple ways to allocate the depreciation amounts over an asset’s lifetime. The straight-line method is the simplest and most common. There are also several accelerated depreciation methods that give companies larger deductions in the early years. This has the effect of reducing income and taxes early on, and then reverse in the later years of the asset’s lifetime.
An asset’s depreciation lifetime is called the recovery period because this is the period in which you recover the original cost through tax deductions. There are two types of recovery periods:
- Generally Accepted Accounting Principles (GAAP): this is the recovery period used for the company’s financial reports. You see this reflected on the company’s balance sheets and financial statements. The recovery period is based on the actual useable lifetime of the asset.
- Modified Accelerated Cost Recovery System (MACRS): this is the IRS system for taking depreciation tax deductions. It provides depreciation lifetimes for all types of assets, running from as few as three years to more than 30.
Each year, you reconcile the differences between your GAAP and MACRS depreciation amounts so that your tax payments are correct.
The accounting rules for the straight-line and alternative methods share the following procedures:
- Determine the year’s depreciation amount with one of the methods described below.
- Record the year’s depreciation figure. You book a debit to Depreciation Expense and a credit to Accumulated Depreciation.
- When the original cost minus the accumulated depreciation equals the asset’s salvage value (or zero if the method doesn’t account for salvage value), you’ve fully depreciated the asset and will take no further depreciation charges.
This is the standard depreciation method, and it’s also the simplest. The recovery period is key to applying the straight-line method:
- Determine the recovery period. For MACRS, reference the IRS recovery period tables.
- Book the annual depreciation expense, equal to (historical cost - salvage value) ÷ recovery period.
Example of Straight-Line Method
Suppose you purchase a delivery van for $45,000, and you assume it will have a salvage value of $5,000 at the end of five years. Depreciation expense = ($45,000 - $5,000) ÷ 5 years = $8,000/year. That’s an annual depreciation rate of 1/5, or 20%. Each year, you debit Depreciation Expense and credit Accumulated Depreciation for $8,000.
Double-Declining Balance Method
As an accelerated depreciation method, the double-declining balance method provides greater depreciation amounts at the start. The depreciation amounts decline as the asset ages.
- Determine the double-declining balance depreciation rate: 200% of straight-line depreciation rate.
- Book the annual depreciation: depreciation rate X net book value at the start of the year.
- Continue until the book value equals the salvage value.
Example of Double-Declining Balance Method
Double the straight-line depreciation rate. For our example van, that’s 2 X 20%, or 40%. Apply that rate for Year One to the historical cost (ignoring salvage value): 40% X $45,000 = $18,000. That’s the first year Depreciation Expense, reducing book value to $27,000. Depreciation for Year Twp is 40% X $27,000, or $10,800, reducing book value to ($27,000 - $10,800), or $16,200. Continue until the book value equals the salvage value of $5,000.
Sum-of-the-Years' Digits Method
Typically, this method is less aggressive than the double-declining method. Please note that the net book value is not used in the sum-of-the-years’ digits method.
- Determine the sum of the digits: s = (n2 + n) ÷ 2 where n is the recovery period.
- Determine the depreciable amount: historical cost - salvage value.
- Create the annual factors by dividing the years remaining by the sum of the digits. For example, the Year One factor is (5/15), the Year Two factor is (4/15), etc.
- Book the annual depreciation: depreciable amount x annual factor.
Example of Sum-of-the-Years’ Digits Method
For our example van, the recovery period is five years. So, add up the following digits: 1 + 2 + 3 + 4 + 5, which equals 15. Alternatively, use the formula: (52 + 5) / 2. Recall that the depreciable amount is $40,000. For Year One, the depreciation expense is (5 / 15) X $40,000, or $13,333. Next, calculate the Year Two expense by subtracting the first year depreciation from the depreciable amount ($40,000 - $13,333), or $28,667, and then multiply by 4/15, getting $7,111. Repeat for the remaining years until the depreciation is zero.
Units of Production Method
This method is appropriate when you want to assign an equal amount of depreciation for each unit or service produced by the asset. You’ll usually see this method employed on production-line assets.
- Determine the depreciation per unit: (historical cost - estimated salvage value) ÷ estimated total number of units that will be produced in the asset’s useful lifetime.
- Multiply the number of units produced for the accounting period by the depreciation per unit.
A company is free to choose the method it will use for depreciation. In theory, it should select the depreciation method that most closely resembles the asset’s actual loss of value. The method should be rational and systematic. An asset that loses its economic value at a fairly fixed rate is best represented by the straight-line method. Other assets that lose value faster in their early years should use an accelerated depreciation method. Nonetheless, companies often use the most aggressive method, as it provides the biggest tax deductions in the early years.