When a company purchases a fixed asset, it must capitalize this asset in its financial records. A fixed asset refers to a large, physical asset that the company plans to use for many years in the business operation. The company determines the total cost of this asset by adding all the costs required to purchase the asset, including purchase price, legal fees and freight costs. The company expenses a portion of the total cost each year through depreciation. Several depreciation methods exist, with various advantages and disadvantages associated with each.

Straight Line

The straight line method involves determining the cost to depreciate and dividing that amount by the number of years the company expects to use the asset. The advantage of using the straight line method involves the ease of calculating the annual depreciation amount. The disadvantage of using the straight line method is that this method does not consider the rate the asset will actually depreciate in value.

Units of Production

The units of production method involves determining the cost to depreciate and dividing that amount by the estimated production units the company expects to manufacture over the life of the asset. The advantages of using the units of production method include the ease of calculating the annual depreciation amount and that the depreciation is matched to the production quantity. The disadvantage of using the units of production method is that this method assumes the asset will depreciate evenly over its productive life.

Declining Balance

The declining balance calculates annual depreciation by calculating a depreciation rate and multiplying it by the remaining asset value. The advantage of using this method is that it accelerates the depreciation recorded early in the asset’s life. Another advantage is that the accelerated depreciation reduces the taxable income and the taxes owed during the early years. A disadvantage of this method is that the calculation is more complex.

Sum-Of-Years Digits

The sum-of-years digits calculates annual depreciation by calculating a depreciation rate by adding up the digits for each year in the life of the asset. Each year the company takes the number of years remaining, divides it by the total digits calculated and multiples this by the asset value. The advantage of using this method is that it accelerates the depreciation recorded early in the asset’s life. Another advantage is that the accelerated depreciation reduces the taxable income and the taxes owed during the early years. A disadvantage of this method is that the calculation is more complex.