Methods of Depreciation
Some of the most common methods used to calculate depreciation are straight-line, units-of-production, sum-of-years digits, and double-declining balance, an accelerated depreciation method. The Modified Accelerated Cost Recovery System (MACRS) is the current tax depreciation system used in the United States .
There are several asset depreciation methods to choose from.
The depreciation method for an automobile should reflect the asset's use throughout its life.
Straight-Line
Straight-line depreciation has been the most widely used depreciation method in the U.S. for many years due to its simplicity. To apply the straight-line method, a company charges an equal amount of the asset's cost to each accounting period. The straight-line formula used to calculate depreciation expense is: (asset's historical cost - the asset's estimated salvage value) / the asset's useful life.
An example of how to calculate depreciation expense under the straight-line method -- assume a purchased truck is valued at USD 10,000, has a residual value of USD 5,000, and a useful life of 5 years. Its depreciation expense for year 1 is USD 1,000 (10,000 - 5,000 / 5). The journal entry for this transaction is a debit to Depreciation Expense for USD 1,000 and a credit to Accumulated Depreciation for USD 1,000. The depreciation expense is reported on the income statement as a reduction to revenues and accumulated depreciation is reported as a contra account to its related Delivery Truck asset account (reduces the asset's cost to its book value).
Units of Production
The units-of-production depreciation method assigns an equal amount of expense to each unit produced or service rendered by the asset. This method is typically applied to assets used in the production line. The formula to calculate depreciation expense involves two steps: (1) determine depreciation per unit ((asset's historical cost - estimated salvage value) / estimated total units of production during the asset's useful life); (2) determine the expense for the accounting period (depreciation per unit X number of units produced in the period).
An example of how to calculate depreciation expense under the units of production -- assume a piece of machinery, purchased for USD 100,000 with a residual value of 40,000, is expected to produce 10,000 units over its useful life. First, calculate the depreciation per unit -- 100,000 - 40,000 / 10,000, or USD 6 per unit. The depreciation expense for the period is the per unit amount multiplied by the period's production amount -- if 1,000 units were produced, depreciation expense equals USD 6,000 (1,000 * 6). This amount is disclosed on the income statement and is part of the asset's accumulated depreciation on the balance sheet.
Sum-of-years-digits
Sum-of-years' digits is a depreciation method that results in a more accelerated write-off than straight line, but less accelerated than that of the double-declining balance method. Under this method, annual depreciation is determined by multiplying the depreciable cost by a series of fractions based on the sum of the asset's useful life digits. The sum of the digits can be determined by using the formula (n2+n)/2, where n is equal to the useful life of the asset.
To calculate depreciation expense under the sum-of-years-digits -- assume a piece of machinery is purchased for USD 100,000 with a residual value of 40,000 and a useful life of 5 years. First, calculate the depreciation rate by adding the years of useful life, or 1+2+3+4+5 (equal to 15). Second, calculate the depreciation expense for year 5 -- 100,000 - 40,000 * 5/15, or USD 20,000. For year 4, the calculation uses the asset's book value (100,000 - 20,000) subtracted by its residual value (40,000) and multiplied by the rate for year 4 (4/15).
Double-declining Balance
The double-declining balance method is a type of accelerated depreciation method that calculates a higher depreciation charge in the first year of an asset's life and gradually decreases depreciation expense in subsequent years.
To calculate depreciation expense, use double the straight-line rate. For example, suppose a business has an asset with a cost of 1,000, 100 salvage value, and 5 years useful life. First, calculate the straight-line depreciation rate. Since the asset has 5 years useful life, the straight-line depreciation rate equals (100% / 5) or 20% per year. With double-declining-balance, double that rate to arrive at 40%. Apply the rate to the book value of the asset (cost subtracted by accumulated depreciation) and ignore salvage value. At the point where book value is equal to the salvage value, no more depreciation is taken.
MACRS
Under MACRS, the capitalized cost (basis) of tangible property is recovered by annual deductions for depreciation over a specified life. The lives are specified in the Internal Revenue Service's (IRS) Tax Co de. The IRS publishes detailed tables of asset lives by asset class. The deduction for depreciation is computed under one of two methods (declining balance switched to straight line or only straight line ) at the election of the taxpayer. Certain limitations may apply.