Many companies calculate their depreciation expense using an accounting method called accelerated depreciation. In this depreciation scenario, an asset, such as a piece of equipment, has its book value reduced on the balance sheet at a faster rate than a traditional straight-line depreciation method. Companies use a few different methods for achieving this, such as the Sum of Years' Digits (SYD) method.
Reasons to Accelerate Depreciation
Companies typically use accelerated depreciation to minimize their taxable income because it allows for greater depreciation expense deductions in the earlier years of the equipment or asset's life. Accelerated depreciation methods could also be seen as more accurate, as they assume that an asset loses a majority of its value in the first few years of its use.
Calculating Sum of the Years' Digits Depreciation
To calculate depreciation charges using the sum of the years' digits method, you'll need to first get the depreciable base, which is the cost of the asset. Second, you'll calculate the salvage value of the asset, which works the same for both the SYD and straight-line depreciation methods. For example, if you buy an asset for $100,000 and it can be sold for an estimated $10,000 at the end of its useful life, the balance subject to depreciation is $90,000, and the salvage value is $10,000. Next, calculate the applicable percentage of depreciation for each year of the asset's life.
For the following example, the cost of the asset is $25,000, with zero salvage value for simplification, and it has a depreciable life of five years. To do this under the sum of the years' digits method, you can use either of the following methods. With the first method, you can take the expected life of an asset in years, count backward to one, then add the figures together. For example, for an asset with five years of estimated useful life, you would perform the following calculation:
5 + 4 + 3 + 2 + 1 = 15.
Alternatively, you can use the following equation to calculate the applicable percentage: depreciable life * (depreciable life + 1) ÷ 2.
Using our current example, this would become: 5 * (5+1) ÷ 2 = 15
The Formula in Action
Using the information from the example above, you would calculate the applicable depreciation percentage for each depreciable year. In the first year, the asset value subject to depreciation would be expensed 5/15 in value (33.33%). In the second year, the asset value subject to depreciation would be expensed 4/15 (26.67%). In the third year, the asset value subject to depreciation would be expensed 3/15 (20%). This would continue until the asset was fully depreciated, having been completely expensed on the income statement and fully depreciated on the balance sheet.
To show the example in table format, the SYD depreciation expense for the life of this asset would be as follows:
|Year||SYD Fraction||Applicable Percentage Depreciation Rate||Annual Depreciation Expense on Income Statement||Remaining Depreciation Base||Salvage Value|
The same asset, using straight-line depreciation and zero salvage value, would be depreciated at $5,000 per year for five years ($25,000 ÷ 5) until the asset depreciates to zero value. The same company, with the exact same assets, would appear to be earning different amounts of profit and have assets carried at different values on the balance sheet, depending upon which depreciation method was utilized. In both cases, the economic reality is the same.