Depreciation Methods

Depreciation Methods

Depreciation Methods

Assets such as machinery, equipment, furniture, lighting etc do not last forever in the same condition but are prone to wear and tear, age, rot, inadequacy, decay or other reasons such as these. Every accounting year a portion of the cost of these assets will be used up. Depreciation is an expense that reduces the value of an asset over a period of time. The use of depreciation can affect the financial statements, by lowering the stated profits in the income statement, and the net value of the asset will decline in the balance sheet.

Depreciation can be determined in various ways depending on the level of use or based on the passage of time. The matching principle is applied to determine depreciation. To an extent that an asset is used up in the operations of an entity, the asset's cost should be subtracted from the revenues that were generated through the use of the asset. However it must be noted that depreciation is not calculated to recognize the loss in market value of an asset or any difference between the original cost and the replacement cost of an asset. The two widely used categories of determining the depreciation are the straight line method and the double declining balance method.

In the straight-line method of depreciation, the salvage value or the scrap value plays a significant role. Salvage value is the remaining value of an asset after depreciation. It can also be explained as the net cash inflow after the asset is liquefied at the end of its life. Salvage value can be zero or negative. In the straight line method the Annual depreciation expense can be shown as (Cost of the fixed Asset residual value) / Useful life of asset in years. Most firms use straight-line method for depreciation to report to stockholders, because in early years of an asset's life it results in lower depreciation expense and a higher net income than the accelerated depreciation method. Now in order to illustrate the straight line method of depreciation, let us take for instance a machinery that may cost 10,000$ and depreciation per year over 5 years can be computed as (10,000 5,000) / 5 = $1,000, if its residual value is $5,000. The Book Value of the asset is the original cost of the asset minus the accumulated depreciation. The book value of an asset less the accumulated depreciation over a period becomes equal to the salvage value at some point.

One another method to compute the depreciation is the double decliningbalance method. Here the rate of depreciation is more in the initial year of the assets life and then decreases gradually, so the book value is multiplied by a fixed rate. The annual depreciation is depreciation rate multiplied by book value at the beginning of the year. The most common rate is double the straight line rate. For example an asset costs $10,000 and its salvage value is $1,000 then the depreciation each year will be 20% for a span of 5 years in the straight line method and is 40 % for a span of 5 years in the double declining balance method. It can also be said that this method applies depreciation rate on the non depreciated balance. Normally in financial statements footnotes have to be referred in order to understand what depreciation methods have been used.

In 1981 the ACRS Accelerated cost recovery system, was founded for depreciable assets. If the deducted depreciation expense is more then the taxable income becomes less. So the ACRS rules simplified determination of useful life of an asset and allowed rapid write-off patterns that are similar to declining balance methods. Hence many firms started using the ACRS method for tax purposes.

In the tax reform act of 1986 Congress changed the ACRS provision and the MACRS Modified Accelerated Cost Recovery System was applicable in the US tax system. Here a capitalized cost is recovered by deduction of depreciation over a period of time by making annual deductions using either the straight line or the declining balance methods. Changing the method in depreciating an asset required IRS approval. It consists of two depreciation systems the GDS General depreciation system and the ADS Alternative Description System. The GDS system uses declining balance method to compute the depreciation of personal property. In the ADS system the depreciation is deducted over longer periods using the straight line method. Normally in MARCS the GDS method is used unless specifically required by law to us ADS.

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