Looking at Depreciation Expense Accounting Methods - dummies

Looking at Depreciation Expense Accounting Methods

Depreciation expense accounting seems straightforward enough: You divide the cost of a fixed asset (except land) among the number of years that the business expects to use the asset. So, instead of having a huge lump-sum expense in the year that you make the purchase, you charge a fraction of the cost to expense for each year of the asset’s lifetime.

But should you divide the cost evenly across the asset’s lifetime, or do you charge more to certain years than others? When it’s time to dispose of fixed assets, the assets may have some disposable, or salvage, value. In theory, only cost minus the salvage value should be depreciated. But in actual practice most companies ignore salvage value and the total cost of a fixed asset is depreciated.

Hundreds of books have been written on depreciation, but the book that really counts is the Internal Revenue Code. The Internal Revenue Code doesn’t give you predictions of how long your fixed assets will last; it only tells you what kind of time line to use for income tax purposes, as well as how to divide the cost along that time line.

The tax law can change at any time, and you can count on the tax law to be extremely technical. The following discussion is meant only as a basic introduction and certainly not as tax advice.

The IRS rules offer two depreciation methods that can be used for particular classes of assets. Buildings must be depreciated just one way, but for other fixed assets you can take your pick:

  • *Straight-line depreciation: With this method, you divide the cost evenly among the years of the asset’s estimated lifetime. Buildings have to be depreciated this way. Assume that a building purchased by a business cost $390,000, and its useful life — according to the tax law — is 39 years. The depreciation expense is $10,000 (1/39 of the cost) for each of the 39 years.

    You may choose to use the straight-line method for other types of assets. After you start using this method for a particular asset, you can’t change your mind and switch to another depreciation method later.

  • Accelerated depreciation: This term refers to several different kinds of methods. What they all have in common is that they’re front-loading methods, meaning that you charge a larger amount of depreciation expense in the early years and a smaller amount in the later years.

    The term accelerated also refers to adopting useful lives that are shorter than realistic estimates. (Very few automobiles are useless after five years, for example, but they can be fully depreciated over five years for income tax purposes.)

    One popular accelerated method is the double-declining balance (DDB) depreciation method. With this method, you calculate the straight-line depreciation rate, and then you double that percentage. You apply that doubled percentage to the declining balance over the course of the asset’s depreciation. After so many years, you switch back to the straight-line method to ensure that you depreciate the full cost by the end of the predetermined number of years.

The salvage value of fixed assets (the estimated disposal values when the assets are taken to the junkyard or sold at the end of their useful lives) is ignored in the calculation of depreciation for income tax. If a fixed asset is held to the end of its entire depreciation life, then its original cost will be fully depreciated, and the fixed asset from that time forward will have a zero book value.

Fully depreciated fixed assets are grouped with all other fixed assets in external balance sheets. All these long-term resources of a business are reported in one asset account called property, plant, and equipment (usually not “fixed assets”). Keep in mind that the cost of land is not depreciated. The original cost of land stays on the books as long as the business owns the property.