Depreciation is a central concept in accounting and is based on the core principle of accrual accounting: the matching principle. In depreciation the cost of noncurrent assets (or those assets lasting more than a year) is allocated over an estimation of the asset’s useful life. This is done to follow the matching principle, which states that expenses should be matched with the revenues that they helped to create over a time period. For example, if a company builds a new factory for $1 million with a useful life of 10 years, they cannot list $1 million on their Balance Sheets right away; they have to depreciation it to match a part of the factory with the revenue it helped to create for a time period. They would have to show $100,000 for 10 years ($1 million / 10 years).
There are many different ways that companies calculate depreciation. The two types of methods are the straight line depreciation method and accelerated depreciation methods. It is important to note that a company could legally use one method of depreciation for financial accounting purposes and another for tax purposes, it will be explained shortly why they would want to do this. First, it is necessary to explain how the methods differ. Straight line depreciation is calculated by taking the purchase price, subtracting the asset’s salvage value (this is an estimation of how much the asset will be worth at the end of its useful life) and then dividing it by its useful life. To illustrate this we can consider the previous example. If the salvage value of the factory is $75,000 then we would take ($1 million – $75,000) / 10 = $92,500. The asset could be depreciated annually at this amount. This means that the asset will depreciate at a rate of 9.25% annually.
Accelerated depreciation methods give a larger depreciation expense in the earlier years of an asset’s useful life and a smaller expense later. Companies will often use accelerated depreciation methods so that they can write off a larger portion of the asset sooner, rather than receiving less money over more time.
One such method is known as 200% or double declining balance depreciation. This method first takes 200% of the straight line depreciation rate then half-way through the estimated useful life of the asset it switches back to straight line depreciation. Using the previous example, 200% is multiplied by 9.25% to give a straight line depreciation rate of 18.5%. Therefore in the first year we would multiply $1 million by 18.5% to get a depreciation of $185,000. Then we would take the remaining total and depreciate that at the same rate. So $1 million – $185,000 = $815,000. We would take this amount and depreciate it at a rate of 18.5% to get $150,775 (this amount will be depreciated in the second year). This process continues until half-way through the useful life of the asset or in this case the sixth year. In that year the remaining balance would be converted to straight line deprecation by taking the remaining amount to be depreciated and dividing it by 5 (for the remaining years).
Another accelerated depreciation method which is used often is the modified accelerated cost recovery system or MACRS. This system was implemented as part of the U.S. Tax Reform Act of 1986 and took affect for assets placed in service after 1986. This method divides fixed assets into classes as well as defines their useful life and depreciation periods using the double declining balance method. The intent of MACRS is so that asset owners can accelerate their write offs of assets for tax purposes.
To make it easier to record different purchase dates in a year the MACRS method uses a half-year convention. It does not matter when the asset is purchased in a fiscal year, a business may depreciate the asset by the value of half a year.
Therefore, the depreciation of an asset with a useful life of 7 years is reported over 8 years, half a year in the first year, then 6 years then another half year in the 8th year.
In this method assets are placed into categories of classes which have 3, 5, 7, 10, 15, and 20 year depreciation’s with the Internal Revenue Service (IRS) specifying which assets are placed in which class. The calculations use double declining balance method. This uses depreciation which is double straight line depreciation. Under straight line depreciation, an asset with a seven year useful life is depreciated 14.29% each year. In the MACRS depreciation the first year’s depreciation is 28.58% (but only amounts to 14.29% since the half-year convention is used). The second year takes the remaining 85.71% (total subtract 14.29%) and depreciates that by 28.58% (or 24.49% of the original). This procedure continues for the next 6 years – then a half-year in the final year.
Depreciating assets is an important part of the accounting process. It tries to smooth out revenue flow by dividing up noncurrent assets over a period of time – that is using the matching principle to match expenses with the revenue it helped to create in the same period.
By Daniel Haagen
Tags:
Accounting
