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

Describe how different depreciation methods of manufacturing equipment and plant affect the cost of the product.

Ans: 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

Depreciation expense is used in accounting to allocate the cost of a tangible asset over its useful life. In other words, it is the reduction in the value of an asset that occurs over time due to usage, wear and tear, or obsolescence. The four main depreciation methods mentioned above are explained in detail below.

#1 Straight-Line Depreciation Method

Straight-line depreciation is a very common, and the simplest, method of calculating depreciation expense. In straight-line depreciation, the expense amount is the same every year over the useful life of the asset.

Depreciation Formula for the Straight Line Method:

Depreciation Expense = (Cost – Salvage value) / Useful life

#2 Double Declining Balance Depreciation Method

Compared to other depreciation methods, double-declining-balance depreciation results in a larger amount expensed in the earlier years as opposed to the later years of an asset’s useful life. The method reflects the fact that assets are typically more productive in their early years than in their later years – also, the practical fact that any asset (think of buying a car) loses more of its value in the first few years of its use. With the double-declining-balance method, the depreciation factor is 2x that of the straight-line expense method.

Depreciation formula for the double-declining balance method:

Periodic Depreciation Expense = Beginning book value x Rate of depreciation

#3 Units of Production Depreciation Method

The units-of-production depreciation method depreciates assets based on the total number of hours used or the total number of units to be produced by using the asset, over its useful life.

The formula for the units-of-production method:

Depreciation Expense = (Number of units produced / Life in number of units) x (Cost – Salvage value)

#4 Sum-of-the-Years-Digits Depreciation Method

The sum-of-the-years-digits method is one of the accelerated depreciation methods. A higher expense is incurred in the early years and a lower expense in the latter years of the asset’s useful life.

In the sum-of-the-years digits depreciation method, the remaining life of an asset is divided by the sum of the years and then multiplied by the depreciating base to determine the depreciation expense.

The depreciation formula for the sum-of-the-years-digits method:

Depreciation Expense = (Remaining life / Sum of the years digits) x (Cost – Salvage value)

Why would some companies favor the double-declining-balance method?

Ans: Most companies will not use the double-declining balance method of depreciation on their financial statements. The reason is that it causes the company's net income in the early years of an asset's life to be lower than it would be under the straight-line method.

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.

Explain the different income tax consequences of the straight-line method versus the double-declining-balance method with an example.

Ans: The main difference between the reducing balance and straight-line methods of depreciation is that while the reducing balance method charges depreciation as a percentage of an asset's book value, the straight-line method expenses the same amount each year.

The most basic type of depreciation is the straight line depreciation method. You use it to write off the same depreciation expense every year. So, if an asset cost $1,000, you might write off $100 every year for 10 years. Your annual depreciation amount never changes.

On the other hand, with the double declining balance depreciation method, you write off a large depreciation expense in the early years, right after you’ve purchased an asset, and less each year after that. So the amount of depreciation you write off each year will be different.