Question

Describe how different depreciation methods of manufacturing equipment and plant affect the cost of the product. Why would some companies favor the double-declining-balance method? Explain the different income tax consequences of the straight-line method versus the double-declining-balance method with an example.

Answer 1

There are several types of depreciation expense and different formulas for determining the book value of an asset. The most common depreciation methods include:

1. Straight-line
2. Double declining balance
3. Units of production
4. Sum of years digits

Straight Line

When using the straight-line method, a company charges the same depreciation expense every accounting period throughout an asset’s useful life, so the effect is a stable and uniform reduction in revenues and asset values in every accounting period of the asset’s useful life.

Here is an example of how to calculate depreciation expense under the straight-line method. Assume a purchased truck is valued at $10,000, has a residual value of $5,000, and a useful life of 5 years. Its depreciation expense for year 1 is $10000−$5000/5=$1000. The journal entry for this transaction is a debit to Depreciation Expense for 1,000 and a credit to Accumulated Depreciation for 1,000. The depreciation expense is reported on the income statement as a reduction to revenues and accumulated depreciation is reported as a contra account to its related Delivery Truck asset account (reduces the asset’s cost to its book value ).

Units of Production

The units-of-production method is calculated based on the units produced in the accounting period. Depreciation expense will be lower or higher and have a greater or lesser effect on revenues and assets based on the units produced in the period.

Here is an example of how to calculate depreciation expense under the units of production. Assume a piece of machinery, purchased for $100,000 with a residual value of $40,000, is expected to produce 10,000 units over its useful life. Depreciation =$6. The depreciation expense for the period is the per unit amount multiplied by the period’s production amount: if 1,000 units were produced, the depreciation expense is 1000*$6=$6000. This amount is disclosed on the income statement and is part of the asset’s accumulated depreciation on the balance sheet.

Sum-of-years-digits depreciation is determined by multiplying the asset’s depreciable cost by a series of fractions based on the sum of the asset’s useful life digits. Sum-of-years digits is a depreciation method that results in a more accelerated write off of the asset than straight line but less than double-declining balance method. This method will reduce revenues and assets more rapidly than the straight-line method but not as rapidly as the double-declining method.

Double-Declining Balance

Double-declining balance is a type of accelerated depreciation method. This method records higher amounts of depreciation during the early years of an asset’s life and lower amounts during the asset’s later years. Thus, in the early years, revenues and assets will be reduced more due to the higher depreciation expense. In later years, a lower depreciation expense can have a minimal impact on revenues and assets. However, revenues may be impacted by higher costs related to asset maintenance and repairs.

To calculate depreciation using the double-declining method, its possible to double the amount of depreciation expense under the straight-line method. To do this, divide 100 per cent by the number of years of useful life of the asset. Then, multiply this rate by 2. Next, apply the resulting double-declining rate to the declining book value of the asset (cost subtracted by accumulated depreciation). Ignore salvage value in making the calculations. At the point where book value is equal to the salvage value, no more depreciation is taken.

>> The double declining balance depreciation (DDB) method is one of two common methods a business uses to account for the expense of a long-lived asset. One reason for using double-declining balance depreciation on the financial statements is to have a consistent combination of depreciation expense and repairs and maintenance expense during the life of the asset. In other words, in the early years of the asset's life, when the repairs and maintenance expenses are low, the depreciation expense will be high. In the later years of the asset's life, when the repairs and maintenance expenses are high, the depreciation expense will be low. While this seems logical, the company will end up reporting lower net income in the early years of the asset's life (as compared to the use of straight-line depreciation). Most managers will not accept reporting lower net income sooner than required.

>> The Difference Between Declining Depreciation and the Double-Declining Method

If a company often recognizes large gains on sales of assets, it might be a sign that the company is using accelerated depreciation methods, like the double-declining balance depreciation method.

Net income will be lower for a number of years, but because book value ends up being lower than market value, there is a bigger gain when the asset is sold. If this asset is still a valuable one, its sale could give a misleading picture of the company's underlying health. However, public companies tend to shy away from accelerated depreciation methods even though accelerated depreciation results in a deferment of taxation liabilities as net income is reduced in the short-term.

For example, suppose the cost of a semi-trailer is $100,000 and the trailer is expected to last for 10 years. If the trailer is expected to be worth $10,000 at the end of that period (salvage value), $9,000 would be recorded as a depreciation expense for each of those 10 years (cost - salvage value/number of years).