GAAP Depreciation

GAAP is an abbreviation of Generally Accepted Accounting Principles or accounting policies. These accounting principles, in some cases, also known as Accounting Standards. GAAP is basically a standardization of accounting policies of all businesses in a certain jurisdiction, country, industry or region. GAAP is not legally binding, though the principles are occasionally used as a way of implementing some legally binding rules. Like in the case of depreciation. The U.S. depreciation methods form the basis for IRS rules and regulations for depreciation deductions which are claimed in income tax returns. GAAP is found throughout the world under several different jurisdictions. The logic of such principles is simple - standardization.

Definition and Meaning of Depreciation

Wear and tear of assets such as machinery or buildings, or even loose tools, results into loss of value of the asset. The wear and tear is also reflected in the book value and the written down value of the asset. Depreciation is a non cash expenditure that is charged for almost all tangible assets. The basic principle is that it is charged for all assets that are categorized as 'capital' assets, i.e. assets that are costly and have a high monetary value.

Methods of GAAP Depreciation

The annual depreciation expense can be ascertained with the help of three different methods. The choice of method that is to be used, depends upon the asset that is to be depreciated and in some cases, the approach of the management of the business.

Straight Line Depreciation Method
The straight line deprecation method is quite a common method of depreciation. Here the following formula is applied to ascertain the annual amount of depreciation:

Annual Depreciation= (Cost - Residual value) / Useful life

The output is subtracted from the book value of the asset. The formula is applied every year to the current book value. In several cases, depreciation of rental property or leased property is ascertained with the help of this method.

Declining Balance Depreciation Method
The declining balance method is quite similar to the straight line method. The only difference is that in the straight line method a direct amount is deducted from the written down value. The declining method however has a specified percentage such as 10%, that is deducted from the asset's written down value. The percentage value always remains the same. In some cases, the percentage rate is mandated by the government. The two formulas that are applied to ascertain depreciation, include:

Annual Depreciation = Book value x Depreciation rate (in %)
Book value = Cost - Accumulated depreciation

It must be noted that in some cases, a double declining method is also used.

Sum of the Year's Digits Method
In order to understand the sum of year's digits method, let us see the formula.

Depreciation Expense = (Cost - Salvage value) x Fraction
Fraction for the first year = n / (1 + 2 + 3 + ... + n)
Fraction for the second year = (n - 1) / (1 + 2 + 3 + ... + n)
Fraction for the third year = (n - 2) / (1 + 2 + 3 + ... + n)
where n=number of useful years left.

The formula is a bit complicated. The important part is of sanctioning of the appropriate value for 'n'. The 'n' represents the number of useful years left. That is, if useful years are anticipated to be 10 then for first year, n = 10, second year, n = 9, third year, n = 8 and so on and so forth.

In some cases the percentages, number of useful years or the rates of deprecation are dictated by the government.