Assets that a company buys and expects to last more than one year are referred to as fixed assets. These can be things such as office furniture, computers, buildings or company cars. Even though the expectation is that they will last longer than a year, these assets do not last forever. The decline of their useful life is known as depreciation. In accounting, depreciation represents a company expense and can be calculated in two ways -- straight line or accelerated.
Assigning an expected useful life to an asset is the first step in calculating depreciation. GAAP, or Generally Accepted Accounting Principals, assigns expected values to assets that can be used by companies when evaluating their assets. For example, the useful life of a computer is typically three years. Because depreciation shows as an expense on the balance sheet, there must be a contra account to balance out the journal entry. This account is called accumulated depreciation. As an asset depreciates over time, a debit is made to depreciation expense and a credit to accumulated depreciation on the balance sheet.
Calculating depreciation is usually done by either straight line or accelerated methods. The straight-line depreciation method utilizes equal annual amounts of depreciation of the asset. To calculate straight-line depreciation the original cost of the asset minus the salvage value is divided by the useful life. Salvage value is the estimated amount that the asset could be sold for at the end of its useful life. An example of straight-line depreciation is as follows: a computer purchased by a company for $4,000 is expected to last for three years and then sell for $1,000. The calculation of depreciation is $4,000 minus $1,000, which equals $3,000. The $3,000 is divided by three, thus the depreciation per year is $1,000.
In the accelerated depreciation model, assets depreciate at a faster rate during the beginning of their lifetime and slow down near the end of the asset’s life. The total depreciation amount remains the same as straight line, however, the depreciation expense is greater up front. There are many different ways to calculate accelerated depreciation, such as 125 percent declining balance, 150 percent declining balance and 200 percent declining balance, also known as double declining. One of the more common ways is to construct a table of declining yearly values.
Why use one method over the other? The most common reason for using accelerated depreciation is to lessen net income. Showing less income lowers the amount of income tax owed by a company. It is better to take income tax savings earlier in the life of an asset. Straight-line depreciation is easier to calculate and looks better for a company’s financial statements. This is because accelerated depreciation shows less profit in the early years of asset acquisition. Most companies use straight-line depreciation for financial statements and accelerated depreciation for income tax returns. This is permissible under GAAP guidelines.