Determining the best method for depreciating tangible fixed assets can be difficult. This article discusses three of the most common methods -- the straight line method, the units-of-production method, and the double declining balance method.
In order to begin depreciating an asset, three things must first be determined.
- the initial cost of the asset
- the expected useful life of the asset
- the estimated value of the asset at the end of its useful life
The initial cost of the asset is the cost to purchase the asset along with any amounts spent to get the asset ready to use. Sales taxes, freight, and installation costs are examples of some of the costs that can be included in the cost of the asset for depreciation purposes.
The expected useful life should be determined at the time the asset is placed in service. According to the Internal Revenue Service guidelines, most machinery and equipment have a useful life of seven years, while automobiles and light duty trucks have a useful life of five years. These guidelines are used for federal income tax purposes; companies may use different guidelines for financial reporting purposes.
The estimated value at the end of a fixed asset's useful life is typically referred to as the residual value. In order to properly calculate depreciation, the residual value must be determined at the time the asset is placed into service.
If a fixed asset is determined to have no residual value at the end of its useful life, the entire cost of acquiring the asset should be expensed over the asset's useful life. When a fixed asset is determined to have a significant residual value, the difference between the initial cost of acquiring the asset and the residual value is considered to be the depreciable cost of the asset. In this case, the depreciable cost is the amount that will be expensed over the asset's useful life.
Straight Line Method
The straight line method is the simplest and most commonly used method of depreciation. It is calculated by taking the acquisition cost of the asset, subtracting any residual value and dividing this amount by the total useful life. As an example, assume that a company purchased a computer for $1,400 with a useful life of three years and a residual value of $200. The computation is as follows; $1,400 acquisition cost - $200 residual value = $1,200 depreciable cost. Divide the depreciable cost by the useful life of three years and the annual depreciation expense using this method is $400 ($1,200/3).
Units-of-Production Method
In some cases, the usage of a fixed asset varies from one year to the next. As an example, assume that a production machine with a cost of $28,000 and a residual value of $4,000 is expected to have an estimated life of 12,000 operating hours. The computation for this method is as follows; $28,000 acquisition cost - $4,000 residual value = $24,000 depreciable cost. Divide the depreciable cost by the estimated 12,000 operating hours for an hourly depreciation rate of $2 per operating hour.
If the machine is used during the year for 1,800 operating hours, the depreciation expense for that year will be $3,600 (1,800x$2). If the machine were used for 2,200 operating hours the following year, the depreciation expense for that year would be $4,400 (2,200x$2). The units-of-production method may be a more suitable choice for this situation in order to properly match depreciation expense with the related revenue.
Double Declining Balance Method
The double declining balance method is calculated by determining the straight line depreciation rate and doubling it. This method greatly accelerates the amount of deprecation recorded for financial reporting purposes in the first few years of an assets useful life. When using this method, it is important to note that the residual value is not considered when determining the depreciation rate, but the asset can never be depreciated below its estimated residual value.
As an example, assume a company purchased a piece of equipment for $80,000 with a residual value of $8,000 and with an estimated five year useful life. The straight line method would be determined by dividing the $80,000 acquisition cost by the five year useful life. This equals an annual depreciation expense of $16,000 or 20%. Using the double-declining balance method, the percentage would double to 40%, therefore, the first years depreciation on the equipment would be $32,000 ($80,000x40%). After the first year, depreciation is calculated using the declining book value of the asset and multiplying by 40%. Because the asset cannot be depreciated below its residual value, the depreciation expense in the fifth year is limited to $2,368($10,368-$8,000) rather than $4,147.20($10,368 x 40%).
Depreciation methods have a significant impact on the income statement and balance sheet of a company. Some companies may choose one method for income tax purposes and a different method for financial reporting purposes. The IRS maintains strict regulations regarding depreciation expense and it is crucial to comply with these regulations. Additional information regarding IRS depreciation guidelines is available on the IRS website.
Additional accounting articles by Diane White Inventory Accounting Methods and Straight-Line and MACRS Method
Diane White - Diane White is the founder and owner of Expert Bookeeping & Tax Service, LLC. She developed her accounting expertise during the ...
