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Fixed assets, such as buildings, factories and machinery, lose value over time. Depreciation is an accounting technique to recognize an asset's gradual loss of value over a prescribed period. Each year, the amount of depreciation is booked as an expense and is also accumulated. Depreciation is booked until the original value less the accumulated depreciation is equal to the salvage value. Different depreciation methods vary in the amounts booked each year. This in turn affects a business’ annual net income and income tax expense.
Independent of which depreciation method is chosen, the annual accounting rules are the same: Calculate the year's depreciation amount using one of the methods described below. Book the depreciation amount as a debit to depreciation expense and a credit to accumulated depreciation. The net book value of the asset is the original cost less the accumulated depreciation. The depreciation amount can be no higher than the difference between the net book value at the beginning of the year and the salvage value. If the net book value at the beginning of the year equals the salvage value of the asset, the asset is fully depreciated and no further depreciation is booked against it.
This is the simplest method. The annual depreciation expense is equal to the original cost of an asset divided by the asset’s useful lifetime. The useful lifetime depends on the type of asset: it can range from two to 20 or more years.
Look up the asset’s useful lifetime: the IRS provide this information. Calculate the straight-line depreciation rate: 100% / useful lifetime. Calculate the annual depreciation: purchase amount * depreciation rate.
Double-Declining Balance Method
This is an example of accelerated depreciation: higher depreciation amounts early in the asset’s lifetime that decrease as the asset ages.
Calculate the double-declining depreciation rate: 200% / useful lifetime. Calculate the annual depreciation: depreciation rate * net book value at beginning of year.
Sum-of-Years’ Digits Method
Another example of accelerated depreciation, though less accelerated than the double-declining method. Note that the net book value is not used in this method.
Calculate the sum of the digits: (n * n + n) / 2 where n is the useful lifetime, in years. Calculate remaining years of service at beginning of year: useful lifetime - years owned. Note that in the first year, the year's owned is zero; in the second year, the year's owned is one and so forth. Calculate this year’s depreciation rate: current remaining years of service / sum of the digits. Calculate the annual depreciation: depreciation rate * original cost.
Based in Greenville SC, Eric Bank has been writing business-related articles since 1985. He holds an M.B.A. from New York University and an M.S. in finance from DePaul University. You can see samples of his work at ericbank.com.