Asset depreciation is an accounting method that allows a business to avoid expensing purchases of assets on its income statements. Each year the company determines the financial portion of the asset that has been used and expenses it on its income statement. While Generally Accepted Accounting Principles (GAAP) offer several methods of depreciation, most companies use just a few select depreciation methods.
Depreciation is the process of reducing the historical cost of an asset by an annual amount relating to the amount of asset usage. Most assets are recorded at historical costs by accounting departments; based on the type of asset, certain methods must be used to reduce the value of the asset each year. Depreciation affects the company financial statements, moving the depreciation amount from the asset value on the balance sheet to the depreciation expense on the income statement.
Several methods of depreciation are used to record the depreciation expense on the accounting books. The most popular methods include:
Straight-Line: This is the simplest depreciation method; it is calculated by subtracting the asset salvage value from the asset's historical cost, then dividing the remaining amount by the useful years of the asset. This creates a constant amount for companies to depreciate each year.
Declining Balance: The declining balance method is used for assets with shorter lifespans for a company. This allows companies to deduct higher depreciation amounts early in the asset life and lower amounts as the asset is phased out of the company. Companies will usually determine what percentage of the asset will be used each year and multiply it by the asset value to determine annual depreciation.
Units of Production: Manufacturing companies may use this method for assets used for production purposes only. It is calculated by subtracting the salvage value from the historical asset cost; this amount is then divided by the total unit production of the machine to get a per-unit depreciation amount. Each month, the units produced are multiplied by the per-unit depreciation amount to calculate the expense.
When calculating depreciation for U.S. tax purposes, all assets entered into service by a company after 1986 must use the Modified Accelerated Cost Recovery System (MACRS). The Internal Revenue Service (IRS) provides asset classes for companies to determine the useful life and asset salvage value for tax purposes. Once the asset life is determined, the IRS provides a table for companies to use when calculating the annual depreciation for each year of the asset life. The IRS has a few alternatives for assets that do not fall under the MACRS depreciation guidelines.