Understanding the concept of depreciation as it relates to financial accounting can be misleading to students learning how to interpret company financial statements. For instance, people tend to look at depreciation as the de-valuation of a fixed asset, and this assessment is supported by the Webster Dictionary meaning of depreciation; to lower in estimation or esteem. But depreciation, as it applies to financial accounting, means something totally different from determining declining market value of an asset. I had always thought the word depreciation meant diminishing value, and I visualize the lawn mower in my garage depreciating, or declining in market value each year. On the other hand the Seagull S6 Original guitar I bought 7 years ago for $329.00 is worth about $399.00 today. It looks and plays as good as the day I bought it. If I generated revenue playing the instrument I could allocate a certain percentage of the purchase cost of the guitar towards the revenue, resulting in a reduction of income and a corresponding reduction in my tax liability. In actuality depreciation is the application of the matching principle through the partial allocation of non-current asset costs to the revenue generated during the accounting period.
The accounting process involved with the allocation of the asset cost is not as straight forward as one might think, but it is accomplished both systematically and logically using either straight line or accelerated methodologies. The straight line method of depreciation is calculated by subtracting a non-current asset’s estimated salvage value from its cost, then dividing the result by the asset’s anticipated years of usage. This is the simplest and most widely used method of asset depreciation and works well for reporting income to stockholders since it results in lower expenses, and leads to greater reported income. The mathematical calculation of annual depreciation expense using the straight line depreciation method is demonstrated below:
Annual depreciation expense = Cost – Estimated salvage value / estimated useful life
Conversely, companies facing large tax burdens would adopt one of the accelerated depreciation methods, perhaps the declining balance method. This depreciation method doubles the straight line depreciation amount, and then the same value is applied to the un-depreciated amount in subsequent years. The result is more depreciation occurs in the earlier years of the assets life. This is particularly useful for depreciating assets that might be replaced before the end of their useful life; things like computer systems. For example a copy machine is purchased for $20,000 with an expected life of 5 years. Notice the salvage value does not enter into the equation as it does in straight line depreciation. The mathematical calculation of declining balance depreciation is demonstrated below:
Year
Depreciation
Year-end Value
1
[$20,000.00/5] = $4,000.00
$16,000.00
2
[$16,000.00/5] = $3,200.00
$12,800.00
3
[$12,800.00/5] = $2,560.00
$10,240.00
4
[$10,240.00/5] = $2,560.00
$8,192.00
5
[$8,192.00/5] = $2,560.00
$6,553.60
The tax reform act of 1986 introduced a depreciation method known as the Accelerated Cost Recovery System (MACRS), and it was created to help stimulate capital purchasing. This method accelerates depreciation by allowing larger tax deductable depreciation to be taken early, lowering the after tax net present value of the asset. Unlike straight-line depreciation that relies on an estimated asset salvage value and useful life predictions, MACRS is based on tables established by the IRS. When compared to straight-line depreciation it results in increased expense and lower tax liability by allowing up to 4 times the depreciation allowed under straight line depreciation. The below chart shows the depreciation amounts under MACRS for a vehicle. The declining percentage shown in the third column is taken from the MACRS half-year convention table which is commonly used. It is important to notice the basis amount does not change from one year to the next, only the multiplier changes each year.
Year
Basis
Percentage
Deduction
2001
$10,000
14.29%
$1,429
2002
$10,000
24.49%
$2,449
2003
$10,000
17.49%
$1,749
2004
$10,000
12.49%
$1,249
2005
$10,000
8.93%
$893
2006
$10,000
8.92%
$892
2007
$10,000
8.93%
$893
2008
$10,000
4.46%
$446
Financial managers know what type of depreciation method to choose. As a general rule a company that has assets that decline in usefulness early would likely choose an accelerated depreciation method like declining method and others may want to use the straight line method. Also for tax purposes, the straight line method is preferred.
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