When most people hear the word depreciation, one of the first things that comes to mind is a car. But in reality, depreciation applies to so much more than vehicles. Depreciation is the documenting of the value of a company’s assets. Whether it’s inventory, software, equipment or something else, accountants are required to report depreciation on financial statements according to the GAAP guidelines. Knowing how to calculate depreciation and which method applies to a particular asset is important in creating true and helpful financial statements for your business. There are four ways outlined in the GAAP, but we will only discuss three here.
1. Declining Balance Depreciation
This method is more of an accelerated depreciation that can be used to write off the costs of depreciations quickly while minimizing tax exposure. Declining balance depreciation doesn’t depreciate assets evenly over time, instead it applies a constant rate of depreciation over an asset’s life. Assets that are far more valuable earlier on in their useful life, like software and other technological items, are prime candidates for this method. If and when this asset is sold, this method tends to generate a larger profit from the sale. This method also includes the double declining balance method for and even faster depreciation of an asset.
2. Straight-Line Depreciation
This method is probably the most popular and perhaps the simplest. It estimates the salvage cost and the useful life of an asset. When the salvage cost is subtracted from the original cost you’re left with the depreciable cost. Depreciable cost is divided equally over the asset’s estimated useful life so that every year, the asset loses the same value. Straight-line depreciation makes balance sheets easy and doesn’t require complex calculations. This method can also be used in many different industries. It should be noted that variations in profits and loss are not an issue with this method.
3. Units of Production Depreciation
Units of production or the activity method gives an equal rate to each unit that’s produced. This method of depreciation is very helpful for companies in the manufacturing sector, like assembly and production lines. The formula for calculating this method uses the cost of an asset based on its original cost and its estimated salvage cost. This is called historical cost. The expense for a particular accounting period is determined by multiplying it by the number of units produced. This method completely ignores the element of time. It should be noted that this method cannot be used for tax purposes.
Of course, nothing lasts forever, and you’ll definitely experience assets depreciating over time. That’s why knowing how to calculate depreciation is necessary within your business. Most businesses stick to one depreciation methodology and depreciation methodologies tend to be industry specific. If you’re still unsure of how to go about reporting your company’s depreciation, don’t be afraid to hire a professional to do it for you. Business accounting is important to knowing the true value of your business, maintaining financial data, tax preparations and so much more.