Depreciation Methods

Depreciation is the concept of matching an expense against revenues that are generated over the life of the expense.  This means that you will be spreading out the cost of the asset over the years that it is operated rather than counting it against the single year that the asset is purchased.  The depreciation cost will be used for financial or tax accounting purposes and there are several methods to spread out the depreciation costs.  A company also has the ability to use one method of depreciation for their financial reporting and then use a completely separate method for their tax reporting.  The reason for using two separate methods for the same asset could be determined by the amount of gain/loss that you want to report in your financial report and the amount of tax credit you want to receive back right away.  For most instances a company will want as much of the tax money back as soon as possible because everyone would rather have more money today then tomorrow.  For this exercise I will go over an example of the different methods of depreciation and why you would use one over the other.  In the example we can say that your company has just purchased a CNC machine that costs $200,000 and has a life span of 10 years.  At the end of the 10 years you are able to sell the machine for the salvage value of $10,000 after it has produced 1 million parts.  Rather than count the asset of the machine against a single years revenues you would spread the amount of depreciation (original minus salvage or $190,000 for this example) over the life of the machine.

The first method of depreciation is called straight-line.  This method would consider the same amount of depreciation expense for each year.  The calculation for determining the rate of depreciation is just 1 divided by the life span, which gives you the rate of 10% for this exercise.  That rate is then multiplied by the amount of depreciation to give you an annual depreciation expense of $19,000 for each of the 10 years.  The straight-line method is the most common method for financial reporting because it shows a lower depreciation expense in the early years of the asset.

The second method is called units of production depreciation.  This is similar to straight-line but is used when considering the amount of depreciation that should be allocated to each part that is produced.  To find that cost you simply take the depreciation total divided by the expected number of parts that will be produced in the life span of the machine.  For this exercise it would be only 19 cents per part.  This method could be used for financial reports if you wanted to break out the depreciation cost per year based on the amount of parts that were actually produced.

The third method is the accelerated depreciation method.  This method will get higher depreciation expenses and lower net income in the early years of the expense.  A common example of this method is the double-declining balance.  Here you would take double the straight-line rate and multiply it by the initial cost.  Then subtract that from the original cost and multiply that difference by double the straight-line rate.  Repeat this for the life span, with the expectation of the final year being the amount needed to bring the depreciation to the cost minus salvage, which for this exercise is $190,000.  That would give you a spread listed below:

The accelerated depreciation methods, specifically the double-declining balance method, would be best used for tax reporting because it would allow you to report the higher amount of depreciation in the early years.  Reporting a higher amount earlier would give you the chance to receive more money back earlier and like I said before, everyone would prefer the money today rather then tomorrow.