There are several different acceptable methods of recording depreciation in connection with your capital assets. Of course, there are advantages and disadvantages of using all of them. This blog will outline just a few of the most common methods. There are three common methods that are used: straight-line, double-declining balance, and sum-of-the-years-digits.
By far the most common is the straight-line method. This method spreads the costs evenly over the life of the asset. It is very easy to calculate as you take the asset value minus the residual value and divide by the useful life of the asset. This is the expense that is recorded in every period for the entire useful life. This makes it very predictable and there are no swings or surprises in net income numbers due to a changing depreciation value. For analysis and managerial purposes, straight-line method is the most useful. However, it may not actually reflect the actual use of the assets. Many assets are more useful right after purchase than at the end of its useful life. The straight-line method does not reflect the actual use of the machine. Therefore, it “costs” the same when it is generating the most value in the beginning and the least value in the end of its useful life. For tax purposes, straight-line does not provide any benefit in the immediate years after the purchases. Every year of its useful life receives the same benefit.
The double-declining balance is the next common method used. This method is a little more complicated to calculate. To calculate depreciation using the double-declining method, you take the book value (cost – residual value – accumulated depreciation) times a pre-determined percentage. This method records more depreciation in the beginning years than in the last years. For example: you buy a $100,000 piece of equipment with no residual value, a useful life of 5 years, and you use a percentage of 40% to calculate double-declining depreciation. In the first year, depreciation is $40,000 ($100,000 x 40%). In the second year, depreciation is $24,000 (($100,000-40,000)*40%). As you can see, there is much more depreciation recorded in the first two years, over 60% of the total depreciable amount is taken in less than 50% of the useful life of the asset. This provides a bigger tax advantage in the first few years than straight-line method. It also allows you to weight the cost of the asset to the years in which it is truly more useful. However, this doesn’t provide for useful managerial analysis as the expenses are always changing.
The last method is the sum-of-the-years digits. This is another complicated method to calculate and track. This calculation uses a fraction of the asset value based on what year it is in the useful life. The denominator of fraction is the sum of the years. For example, if there is a five year useful life, the denominator is 15 (5+4+3+2+1 = 15). The numerator is the number of years left in the useful life. In the first year, you would take 5/15 * the asset value. This method would record an even greater depreciation amount in the first few years than even the double-declining method. It has the same tax advantages as double-declining and also makes it difficult for managerial analysis. These two methods are providing tax advantages in the first couple years that straight-line does not.
Of course, you can use a different method for both tax and book purposes to get the best of both worlds: the analysis and simplicity of straight-line method and the tax advantage of either of the other two methods.Written by: Ashley Peth TGG Accounting