Depreciation a Comparison of Depreciation Methods: Income

Depreciation

A Comparison of Depreciation Methods: Income and Tax Consequences of Various Accounting Practices

Depreciation is something that any business organization or entity must deal with on an ongoing basis for a variety of reasons. All consumers experience the effects of depreciation, in fact, though it is typically not necessary for average consumers to explicitly and consciously account for the depreciated values of their assets. For businesses, however, such depreciation is often mandated as a means of determining an accurate valuation for a company's assets and the degree of shareholder worth and profit potential that these assets might generate (Albrecht et al. 2008). Most assets that companies use in their day-to-day operations such as facilities, equipment furniture, vehicles, computers, etc., begin losing value the moment they are purchased and start being used, and all with a financial interest in a given business organization have a right to know the actual value of a company's assets at a given point in time (Albrecht et al. 2008; Bryant 2010).

In addition, tax right offs for business expenses are dependent on accurate calculations of the depreciation of a company's assets (Albrecht et al. 2008; Bryant 2010). It is this area that many organizations find significant differences in the methods for calculation of the depreciation of their assets; some methods can present significant tax savings over other (Bryant 2010). This paper will compare straight line deductions, the unit-of-production method, and the declining balance method, analyzing the practicalities of their calculation as well as their effects and benefits.

The Methods

The straight-line depreciation method is by far the simplest depreciation accounting method and makes the most intuitive sense at first glance (Albrecht et al. 2008; Bryant 2010). In this method the cost of an asset is simply divided by the number of years of useful life the asset will provide to the business organization, and the resulting amount is the amount deducted for the asset each year that it is utilized by the company (Albrecht et al. 2008; Bryant 2010). For example, a fifteen hundred dollar computer that would be useful for three years would receive a deduction of 1500/3 dollars per year, or five hundred dollars a year over three years in the straight-line depreciation accounting method (Bryant 2010).

The unit of production accounting method is not exactly suitable for all assets. As the name implies, this accounting method notes the depreciation of a given asset not over time, but over the amount that the asset is actually used (Albrecht et al. 2008; Bryant 2010). Computers, for example, do not really depreciate based on the amount of data that they store and transmit, and thus this accounting method would not be appropriate for this type of asset (Albrecht et al. 2008). Vehicles and many other pieces of equipment, however, do depreciate based on the amount they are used; a car with higher mileage is worth less than the same year's model will less mileage. In this accounting method, usable life would be determined by a certain measure of production (100,000 miles on a car, for example) and the yearly tax deduction would be taken based on the number of units produced divided by the total (Bryant 2010).

Assume that a given vehicle purchased by a company for business use has an estimated useful life to that company of one hundred thousand miles. If the vehicle costs twenty thousand dollars, then its depreciation value is simply $20,000 (the cost of the vehicle) divided by 100,000 (the number of useful units the vehicle can produce), or .2 dollars per unit of production, or twenty cents a mile. If the vehicle is driven twenty thousand miles in its first year of operation and thirty thousand miles in its second, the depreciation for each year would be four thousand dollars and six thousand dollars, respectively. This accounting method does not need to be utilized for assets that depreciate in this manner, but it can be useful to receive higher tax breaks in certain years (Albrecht et al. 2008; Bryant 2010). It should also be noted that any resale value of the vehicle (or any other asset) at the end of its useful life to the organization should be deducted from the initial cost of the vehicle, which was not accounted for in the example provided above (Bryant 2010).

Another more complex method of depreciation accounting is the declining balance method, which allows for larger tax write offs in the initial years following an asset purchase, with declining depreciation values in each subsequent year (Bryant 2010). This accounting method, unlike the unit of production depreciation accounting method can be used for any asset, though it is more specifically intended for assets that actually decline in value with greater rapidity (Bryant 2010). There are also specific formulas that are typically used in the declining balance depreciation accounting method, and these are more complex than other calculations.

They begin, however, in the same manner as calculations for the straight-line deduction, with the cost of the asset divided by the number of useful years of life the asset will provide to the organization. In order to create larger deductions in early years, however, deductions from later years must be diminished to an equal degree (Bryant 2010). One of the common ways of accomplishing this is to multiply the first year's amount by two hundred percent and essentially eliminating the value of the asset by a year, then multiplying the next year's depreciation amount by another number -- say, one-hundred-and-fifty percent -- leaving the remainder -- fifty percent -- for the second to last year, and proceeding in a like manner through all the years of the assets values. The depreciation value in the middle year (the third year in a typical five-year depreciation progression) would be equal to the amount of yearly depreciation in a straight line accounting method.

Uses and Benefits

Most organizations use straight line deductions for the majority if not the entirety of their assets, but no organization is required to use only one specific accounting method nor would this necessarily be advisable. Despite the benefits that can be gained from the simplicity of utilizing the straight line deduction method for all depreciation purposes, there would likely be some tax disadvantages to this use (Albrecht et al. 2008; Bryant 2010). As will be demonstrated, however, the type of organization is not really as important in making this determination as is the type of asset being considered and other environmental factors.