No production facility can last forever. Equipment wears out, facilities undergo wear and tear and machines become obsolete. When trying to get a picture of the current status of a company, the state of its physical assets is something that needs to be considered — not only practically but financially as well. In accounting, the portion of equipment that is “used up” every year is represented by depreciation, which is a way to capture the cost of normal production use for equipment or a facility.
There are four different methods for depreciating assets under GAAP: straight line method, units of production method, declining balance method and the sum of years. Different rules apply depending on which method you use.
Land is not considered to be something that depreciates, as land is not used up and does not wear down. However, physical structures on land (including buildings, fences and roads) are included in the calculation of depreciation values for accounting purposes as well as all types of equipment in use within the business.
The estimations and math for depreciation could easily become confusing, but generally accepted accounting principles provide a set of standards to do so. GAAP depreciation methods are a combination of standards, principles and procedures provided by policy boards to accountants to help consistency, compliance and analysis.
GAAP depreciation conventions are generally focused on American businesses, although with markets expanding across the world, many companies have transitioned to using the International Financial Reporting Standards to keep compliant with their international suppliers and customers. Nonetheless, GAAP still forms the core of accounting standards used in the U.S. and is required when a business distributes its financial reports outside of the company.
In order to calculate depreciation values for an asset, four factors need to be considered:
- Asset Cost: The cost of any structure, facility or equipment includes not just its purchase cost but the cost of taxes, freight and installation. This is the sum of the costs it takes to get the new asset from purchase to working order. Even if some of the costs are internal, they should be added.
- Asset Lifetime: An estimate should be made as to the number of years the company expects this asset to continue to work or in some units of production that represent the equipment’s lifetime. The vendor can help estimate this.
- Residual Value: Also called scrap value or salvage value, this is the amount of value left in an asset after its useful life ends. This might sound counterintuitive, but for example, a car whose engine doesn’t work still has value left in its tires, doors and components. Thus, even though the asset may have reached the end of its lifetime, there is still some residual value to be had from it.
- Method of Depreciation: Under GAAP, there are four different models that can be used for depreciating assets.
The asset’s lifetime and residual value are likely to be estimates. This is because all pieces of equipment have minor differences, uses may change over time and human error might introduce a break or flaw that was not considered. The manufacturer of the equipment should be able to help predict lifetime, and if similar equipment has been used in a facility before, that can be taken into consideration.
As for residual value, that can be estimated based on a number of factors including the local cost of scrap metal or an understanding of a machine’s individual parts. The estimate should be as accurate as possible, but the calculation of depreciation can be done with estimates and still be formal in the accounting books. It’s just important to note the rationale and logic used to approach the situation and the technical knowledge used to decide on reasonable estimates for the asset.
There are four main models of depreciation under GAAP. Each model has its own strengths and weaknesses, and accountants should consider all angles when deciding what type of depreciation to record in the books.
The straight-line depreciation method is a simple calculation, dividing the depreciable value (the asset cost – the residual value) over the years of active life. The depreciation assumption is thus the same number every year for the number of years the asset is considered to be in use.
The advantage to this method is that it’s simple to calculate and very straightforward for budgeting over multiple years. The disadvantage is that it doesn’t necessarily represent the rate at which the asset actually depreciates.
For example, a new car may lose much of its perceived value up front, but if depreciation is calculated linearly, the value in the books won’t accurately represent the actual value in the car. Alternatively, the asset might perform well in its early years of usage but not as well toward the end of its life. Either way, the perceived value of the asset would be different than that represented in the books.
The units of production depreciation method is used when the lifetime of an asset is defined in hours of operation, units produced or another iteration affected not just by time but by usage of the asset. In this case, depreciation is calculated based on the production rates the company expects to manufacture while the asset is in use.
The advantage is that with new equipment where projected production rates may start low initially and then increase over time, the equipment will depreciate on the books in the same way.
The disadvantage is that this method assumes depreciation is again linear, this time over rate of production. There’s no guarantee that the asset will depreciate at a constant, even rate over its lifetime. It can also be more difficult to predict rates of production.
Declining balance depreciation is a more aggressive method of depreciation meant to represent heavy depreciation of the asset’s book value in its earlier years and then taper off the depreciation rate in later years. This method starts by assuming a factor of depreciation rate as a percentage, and each year the asset’s book value is depreciated by that percentage.
For example, at a 40% depreciation rate for a $100 asset, the first year’s depreciation would be $40. The second year, the book value ($60) is then depreciated at 40 percent, meaning $24 is depreciated, and $36 remains on the books. This continues until the estimated end of life of the asset. In this case, the asset may not be depreciated below its residual value.
The advantage is that this sort of depreciation reduces taxable income in the early years of the asset’s life. The disadvantage is that it’s more complex to calculate for individual assets.
The sum of the years’ digits depreciation method is also a more aggressive depreciation model meant to capture heavier depreciation in the early years of the asset’s life. It is a percentage depreciation model, but the percentage changes over the lifetime of the asset.
In this model, the sum of the number of years in the asset’s lifetime is taken. For example, three years of life would give a sum of 1 + 2 + 3 = 6, and five years of life would give 1 + 2 + 3 + 4 + 5 = 15. The depreciation rate is then calculated by dividing the number of years left in the lifetime by this sum. For example, the first year of an asset with three years of life would be depreciated by 3/6, or 50%. The second year, this would be depreciated by 2/6, or 33%.
The advantages are much the same as the declining balance depreciation. Weighting depreciation more heavily in earlier years provides some tax relief and often better represents the actual value of the equipment left. The disadvantage is that it is more complicated to calculate, especially for companies that have many assets.
The most commonly used method of depreciation is the straight-line calculation, as it is the simplest to calculate, and for many assets like buildings or general equipment, usage doesn’t vary enough from year to year to make any additional calculations necessary.
The next most commonly used methods are the two more aggressive methods: declining balance depreciation and sum of the years’ digits depreciation. These are used mainly for tax-break purposes but can make budgeting more difficult for managers who aren’t necessarily aware of the method of calculation.
Depreciation based on units of measure is the least widely used, mainly because it can be difficult for the accounting department to accurately estimate the usage, and production rates can change over time.
The two more aggressive methods will produce the highest amount of depreciation in the early years. Accelerating the depreciation rate allows the company a break on income taxes (as capital and depreciation values are accounted for against a company’s income as investments) by lowering the overall income against the depreciation loss.
In some cases, this can work out because in later years when the depreciation amount is lower, the company might be expected to have more income due to whatever asset has been installed, allowing them to cover more of the tax deduction while still maintaining the bottom line.
Most businesses choose a method by considering when the tax deduction would be the most useful: early in the lifetime of the asset or later in life as the asset is reaching the end of its useful years?
Businesses can choose to depreciate different assets in different ways depending on how they believe the asset will be used and how they want to capture the portion that’s “used up” annually. A business with many assets may choose to simplify its accounting with the straight-line method, while a business with a few expensive assets may want to more accurately represent expected depreciation with one of the more aggressive methods.
It’s also fairly common practice for a company to use, for example, the declining balance method on its income tax returns but internally use the straight-line method when evaluating its managerial accounting and financial reports.
There’s no harm in doing this as long as each version clearly states the assumptions made and as long as all tax-related submissions are consistent. Accounting departments often evaluate balance sheets using different methods of depreciation to determine which is the most advantageous for the business based on the magnitude of the asset in question.
Any business that deals with a good number of physical assets — manufacturing, refining or chemical industries, for example — should consider the accounting side of the equation and how best to represent the wear and tear on everyday equipment and facilities. No plant will last forever, and correctly tracking depreciation will help in future planning when managers need to make proposals for capital budget projects to improve or replace their current equipment.
The biggest advantage of depreciation in accounting is the fact that it can be set against a company’s income to reduce income taxes due, so the purchase of new assets and their addition into the books needs to be done strategically not just for production but for accounting and finance as well.