Depreciation is the recognition of a loss in value of a long-term asset due to wear and tear over the course of its useful life. The four most common depreciation methods include: straight-line, units of production, double-declining balance, and sum-of-the-years'-digits.
The straight-line method is the most widely used and simplest way to recognize depreciation. In straight-line depreciation, the asset is depreciated in equal amounts each year over the course of its useful life. To apply straight-line depreciation, take the cost of the asset and subtract the residual value to determine the depreciable value. Divide the depreciable value by the number of years of its useful life to calculate the annual depreciation expense.
The units of production method allocates the cost of a long-term asset based on the actual usage of the asset. First, determine the depreciable value, then divide by its productive capacity (for example, total miles driven on a vehicle before it is considered fully depreciated). This calculation results in the depreciation expense per unit. Then multiply this amount by the units of production for the year to calculate annual depreciation expense.
The double-declining balance method is an accelerated depreciation method used when the long-term asset is considered to be most valuable during the first years of its use. Double-declining balance does not use residual value as part of the calculation. Instead, the current book value is used. First calculate the annual straight-line depreciation rate, then double this rate to obtain the double-declining-balance rate. Multiply the book value by the double-declining-balance rate to calculate the depreciation expense for the first year. For subsequent years, the book value is reduced by the previous year's depreciation expense. Therefore, the depreciation rate will remain the same, but the annual depreciation expense decreases each year.
She sum-of-the-years'-digits (SYD) method is also an accelerated depreciation method, but it is not as severe as the double-declining balance method. First, determine the asset's useful life in years. Then add the digits of the years in the asset's useful life. For example, to calculate the SYD of an asset with a 5-year useful life, the calculation would be 5+4+3+2+1=15. This value is the denominator of the fraction, while the year is the numerator, with the largest numerator first. To determine the annual depreciation expense, the depreciable value is multiplied by the year's fraction (i.e.. 5/15, 4/,15, 3/15, 2/15, and 1/15) so annual depreciation expense decreases each year.