Depreciation is a complex accounting technique used to recognize large expenses. Accountants use depreciation to spread the recognition of large cash expenses over a long period of time to reduce the impact on current-period income and ratio valuations. Note that depreciation does not have an effect on the actual flow of cash -- only the expenses reported on paper. If a company pays $50,000 cash for a machine, for example, it will incur a $50,000 expense immediately, even though accountants only recognize a fraction of the cost in the current accounting period.
Under the straight-line depreciation method, accountants spread the total cost of a purchase evenly over the expected life of the asset. If a truck is expected to last 30 years, for example, accountants would divide the purchase cost by 30, then recognize an equal amount each year over the entire 30 years. Straight-line depreciation involves the simplest calculation of all depreciation methods, but this method does not always accurately reflect the true use or physical deterioration of assets. In cases where specific depreciation numbers are needed, accountants can turn to the units-of-production method.
The units-of-production method of depreciation approximates the cost of each unit expected to be produced by an asset, recognizing a more literal amount of depreciation expense each period. Just as managers can estimate the expected life of certain assets, they can also estimate the expected total output over certain assets' useful lives. Accountants can then divide the purchase cost of an asset by the expected output to arrive at a cost per unit produced. The truck mentioned above, for example, might be expected to run 750,000 miles throughout its 30-year expected life. Thus, an accountant would divide the cost of the truck by 750,000 to find a cost per mile, then recognize a depreciation amount equal to the cost per mile times the actual number of miles driven during a given period.
Generally Accepted Accounting Principles (GAAP) allows for two additional depreciation options: the declining-balance method and the sum-of-the-year's-digits methods. The declining balance method recognizes a different amount for depreciation each period, based on the current book value times a set depreciation rate. The sum-of-the-year's-balance method takes both the number of years left in an asset's useful life and the number of units produced per year into account to determine a more exact amount.
The units-of-production method can be more useful for determining exact profitability figures for productive assets, products, departments or business units. Continuing the trucking company example, company accountants can use the units-of-production method to determine exact costs per mile for both the company and its independent contractors.
The straight-line method can be more useful for assets that cannot be conveniently pegged to specific output. The straight-line method can make more sense for depreciating cash outlays for buildings and facilities, for example.
- University of California, Northridge: Depreciation, Amortization, Depletion
- BKD CPAs and Advisors; Units-of-Production Method of Depreciation; Rick Carrier Jr.; May 2011
- Alamo Colleges; Units-of-Production Depreciation Method; Gerald F. Manahan Jr.; February 2009
- CliffsNotes: Depreciation of Operating Assets