Anyone who runs a business knows that assets don't last forever. Machines wear out, vehicles need more servicing the older they get, and manufacturing equipment can quickly become obsolete. All of these things affect the asset's value. If you recorded the assets at their original purchase price, then anyone reviewing the accounts would think that the company's assets are worth far more than they actually are. Generally accepted accounting principles, or GAAP, injects a dose of reality into the company's accounting by showing how an asset loses value over time.
What Is GAAP Depreciation?
GAAP works on the assumption that just about every type of business asset loses value over time. If you bought a cutting tool for $10,000 in 2015, for example, then it's unlikely that you would get $10,000 for it if you tried to sell the tool in 2020. The fact is, assets do not last forever. At some point they are going to wear out, break down and require greater upkeep and servicing – and this degradation in quality is reflected in the value.
To ensure consistency among organizations, GAAP has introduced a set of accounting procedures for depreciation, which ensure that asset depreciation gets recorded in the most appropriate way. "Depreciation" in this context is a way of allocating the cost of an asset over a number of years. For tax purposes, companies are not permitted to expense the cost of a long-term asset when they purchase the asset. Rather, they must depreciate or spread the cost over the asset's useful life.
Not every business is required to use GAAP accounting. However, its protocols serve as the gold standard for businesses that wish to achieve transparency in their accounting.
Four GAAP Models
There are four different ways to depreciate assets under GAAP:
- Straight line method
- Declining balance method
- Units of production method
- Sum of years' digits
Each method will achieve the same result, which is writing off the cost of the asset over the life of the asset. But the timing of the depreciation will be different in each case. This has an indirect impact on cash flows, since depreciation can reduce the amount of taxable income and, therefore, defer income tax payment to later years.
Under GAAP, accountants and managers are responsible for figuring out the correct GAAP depreciation method to use based on their best judgment of which method will achieve the most satisfactory allocation of cost. The straight line and declining balance are the most popular methods of depreciation, so these are described in a little more detail below.
Three Key Information Points
Whichever method you choose, accountants will need to determine three specific data points before they can depreciate an asset under GAAP:
- The total cost of the asset, which is everything you spend to get the asset bought, installed and working for the business. Besides the purchase price, you'll need to figure in the cost of taxes, shipping and installation.
- The GAAP useful life of assets, which is your best estimate of how long the asset will last before you have to replace it. The IRS useful life table is essential guidance here. For example, the IRS provides for a five-year life on computer equipment.
- The asset's salvage value, which is how much you can sell or scrap the asset for at the end of its useful life. Many assets have no salvage value, as they eventually become obsolete and worthless.
Method #1: Straight Line Method
The straight line method is by far the most popular method of depreciation and is extremely simple to calculate. Here, you take the total cost of the asset, deduct the salvage value and divide the resulting number by the asset's useful life:
(total cost - salvage value) / useful life
For example, suppose you spend $10,000 on computer equipment that you estimate will last for five years. After five years, the computers will be obsolete and you will simply throw them away. Using the straight line method, you must depreciate the computers by $2,000 per year, every year, for five years. On the books, your computers will be worth $10,000 in the first year, $8,000 in the second year, $6,000 in the third year and so on, until you reach a final balance of zero in year five.
The benefit of this method is simplicity: you're recording the exact same deduction every year. The downside is that your figures may not reflect reality. Some assets, like vehicles and computers, don't lose value in a linear fashion at the same rate each year. Rather, they might lose half their value in the first two years, and then decline in value gradually over the rest of their useful life. For these assets, the declining balance method will ensure that the actual value of the asset is represented in the company's books.
Method #2: Declining Balance Method
The declining balance method is useful for assets that depreciate aggressively in the earlier years of their life compared to their later years. Here, you depreciate the asset according to a fixed percentage rate, which is the percentage of its value you think the asset is going to lose in each year of its useful life. The formula looks like this:
(net book value - salvage value) x percentage rate
There's a new piece of accounting jargon here and that's net book value. NBV is the asset's value at the start of the year, and you calculate it by deducting the depreciation you've accumulated to date from the total cost of the asset.
The easiest way to understand the declining balance method is by running an example. Let's return to the computers from the example above only instead of using linear depreciation, assume the computers will lose 30 percent of their value every year. Here's what the depreciation schedule looks like, based on the declining balance method:
- Year 1: $10,000 x 30 percent = $3,000
- Year 2: $7,000 x 30 percent = $2, 100
- Year 3: $4,900 x 30 percent = $1,470
- Year 4: $3,430 x 30 percent = $1,029
Year 5 works a little differently. Under GAAP, it's important that depreciation is charged in full, so the total amount of depreciation for the computers needs to add up to $10,000. In other words, the final year's depreciation must be the difference between the NBV at the start of the final period (here $2,401) and the salvage value (here $0).
Despite this final-year adjustment, you can see how the depreciation schedule declines for each year of the asset's useful life, rather than being a fixed deduction like you get under the straight line method.
Method #3: Units of Production
Mostly used for tax purposes, the units of production method defines the useful life of an asset according to the number of units produced or its hours of operation, instead of the time usage of an asset. These metrics are much more relevant to production managers who wish to achieve a certain number of production runs before the machinery is retired.
The calculation is not dissimilar to the straight line method, and you get a linear depreciation rate, this time based on the rate of production. Of course, there's no guarantee that your machinery will depreciate at a constant rate, which means the recorded value of your asset may not reflect reality.
Method #4: Sum of Years Depreciation
The sum of the years' digits method is the most complex form of depreciation under GAAP, although fundamentally, it works the same way as the declining balance method. The difference is that now, you can allocate a different percentage of depreciation for every year of the asset's useful life. This method is called "the sum of years' digits" because you add up the digits in the years of the asset's useful life – a useful life of 3 years gives you 1 + 2 + 3 = 6; a useful life of 5 years gives you 1 + 2 + 3 + 4 + 5 = 15.
The resulting number becomes the denominator of the fraction you'll use to calculate the depreciation percentage. The numerator is the number of years of useful life remaining.
For example, an asset with three years of life would be depreciated by:
- Year 1, 3/6 or 50 percent
- Year 2, 2/6 or 33 percent
- Year 3, 1/6 or 16.67 percent
The sum of years method lets you weigh the depreciation schedule more heavily in earlier years, which provides a better indication of value for fast-depreciating assets. On the downside, it is much more complicated to calculate, especially for asset-heavy businesses.