Depreciation Methodology

Depreciation allows you to expense the use of an asset in the correct period.

One of the most important things accountants do is to try to match up the expense of using an asset during the time it was used. To do this, they use a process called depreciation. Depreciation can take several forms, depending on the asset and the length of time the asset is expected to be in use. All of the methods are correct to use, but they will affect the financial statements differently. Knowing how they affect the bottom line will help you determine which depreciation method to use.

Definition

When you purchase an asset for your business, such as a car, you have a large cash expenditure up front. However, Generally Accepted Accounting Principles (GAAP) state all assets have to be expensed in the period they were used. This means the expense for buying the car has to take place in the month the car was used. When you own the car over a long period of time, a portion of the car's value is expensed, or depreciated, each month you own the car.

Straight Line Depreciation

The easiest way to depreciate an item is to use straight line depreciation. To use this method of depreciation, you divide the total cost of the item by the number of periods you believe the item will be in use. That amount is then expensed each month until the asset is completely depreciated. For example, if you spent $10,000 on a car and you plan on having that car for five years, you would depreciate $2,000 per year, or $166.66 per month of use, on that vehicle.

Double Declining Balance

This method approaches depreciation by deciding an asset will get the most of its useful life in the beginning of the firm's ownership. Because of this, more depreciation expense is given to the asset earlier in its life. For example, instead of depreciating 20 percent of the car's initial cost per year, you depreciate 40 percent of the car's carrying value. The first year, the car will carry a $4,000 depreciation expense, leaving $6,000. The second year, the car will have an expense of $2,400 (40 percent of $6,000). This continues until the asset is depreciated.

Sum of Years Digits

The sum of years digits method of depreciation uses a percentage of the cost over a period of time to depreciate the asset. For this method, you add up the years which the asset is believed to be used for as if they were whole numbers, and the expense will be a fraction of that total number. In this example, the sum of years will be 15 (1+2+3+4+5) for a five-year automobile useful life. In year 1, we calculate the depreciation expense based off how many years of useful life is left at the beginning of the year. For the car, it would be $10,000 x 5/15, or $3,333.33. In year 2, the depreciation would be $10,000 x 4/15, or $2,666.66. This calculation is done every year until the car is depreciated.

Units Used

The final method of depreciation is done by estimating how many units an asset will produce and then dividing the cost of the asset by that unit total. Usually used in manufacturing, this method is not used very often, as it is difficult to get an idea of how many units will be produced. In the car example, you might decide the car will get 80,000 miles before it needs to be sold. In this case, you will depreciate $0.125 per mile until the car is fully depreciated.

References

• Accounting Info: Depreciation Methods
• Investopedia: Depreciation