Depreciation is used to gradually charge the book value of a fixed asset to expense. There are several methods of depreciation, which can result in differing charges to expense in any given reporting period. The following are the general methods of depreciation available for use:
- Straight line. The straight-line method charges the same amount of depreciation to expense in every reporting period. This approach probably approximates the average usage pattern of most assets, and so is a reasonable way to match revenues to expenses. It is also the easiest depreciation method to calculate, which makes it by far the most commonly-used depreciation method.
- Accelerated. An accelerated depreciation method is designed to charge the bulk of the depreciable amount of a fixed asset to expense as soon as possible, with a rapidly-declining amount being charged to expense in later periods. Examples of this method are the double-declining balance method and the sum of the years' digits method. This approach is useful for depressing short-term profits in order to reduce the amount of taxable income. However, it is difficult to calculate, usually does not reflect the actual usage pattern of a fixed asset, and skews the reported results of a business.
- Usage based. A usage-based depreciation method is designed to have a variable periodic depreciation expense that is based on the amount that a fixed asset is actually used. An example of this method is the units of production method. This is the most accurate of the depreciation methods in matching actual usage to the related depreciation expense, but suffers from an inordinate amount of record keeping to track usage levels. Given this problem, it is usually restricted to the more expensive fixed assets whose usage levels vary considerably over time.
Of the methods of depreciation noted here, the most practical one is the straight-line method, since it requires minimal upkeep and is the easiest to understand. The only value of an accelerated method is in deferring the payment of income taxes. A usage-based method should not be used unless there is a demonstrable need for an increased level of depreciation accuracy, since it is a time-consuming approach.
Any method of depreciation is time-consuming over the lifespan of an asset, and so is not efficient. To improve the efficiency of the accounting staff, set a high capitalization threshold, below which all expenditures are charged to expense as incurred. Doing so can eliminate a large number of depreciation calculations.
From an auditing perspective, it is best to use the straight-line method, since these calculations are easiest for auditors to verify. This can reduce the annual audit fee charged to a business.