Depreciation: Summary of Main Methods - Online Tutor, Practice Problems & Exam Prep

Depreciation allocates the cost of a fixed asset over its useful life, using methods like the Straight-Line Method, Double Declining Balance Method, and Units of Production Method. Key variables include cost, useful life, and residual value. Depreciation is a non-cash expense, impacting net income and taxes. The total depreciation remains constant across methods, but timing varies. Companies often prefer the Straight-Line Method for simplicity, while the IRS allows accelerated methods like MACRS to incentivize investment.

Depreciation: Summary of Main Methods

Alright, so we've discussed the 3 most important depreciation methods. We've talked about the straight-line method, the double declining balance method, and the units of production method, alright? So now what we're going to do is just summarize all of that on one page, so you have it easily accessible when you're studying. Let's check it out. So depreciation, remember this is when we buy a fixed asset that we're going to use for a number of years and we're splitting up that cost over its useful life. All right? And when we calculate depreciation, there were 3 things, 3 variables that were very important when we are calculating the depreciation. Do you remember what they were? We had cost, we had useful life, and we had residual value, right? And remember that these 2, useful life and residual value, they are estimated. Okay? Those are estimated by the company. All right? So another note about depreciation is that depreciation is a non-cash expense. Okay? Even if it doesn't make total sense to you now, drill it in your brain that it's a non-cash expense, right? Because when we take depreciation, we're not paying cash for that depreciation. No, that's just wear and tear on our machine, there's no more cash outflow. We already made the cash outflow when we bought the machine itself, okay? And remember that when we talk about depreciation, we're talking about a net book value. We calculate a net book value, but this net book value does not relate to the market value of the asset, okay? They're not necessarily going to coincide. What you can sell it for might not be what the net book value is at that time. Because we could use different depreciation methods and end up with different net book values at any given point in time, okay? So it's just trying to best match how we're using the machine and match those expenses to our revenues, okay? So this is a summary of the formulas we used when we were doing different depreciation methods. The straight-line method, we've got on the top. And then in the second one, we've got the rate. Remember this is the depreciation rate that we had in the double declining balance method. This isn't how we calculate depreciation expense itself. This one was probably the most complicated, and if you're going to study 1 a little extra, make sure that you put a little more time in that if your teacher is going to focus on the double declining balance rate. That one's definitely the toughest one to do. Okay? And then on the bottom one, remember this one is depreciation per unit. We get a per-unit amount and then find how many units we did in the units of production method. And the difference here is that our denominator has the units of output. In the other methods, we have time periods, years, something like that. Where in the units of production method, what we have are the units of output. Okay? So remember, this is the straight-line method here. SL for straight line, double declining balance, and then units method over here. Okay? So when we are studying these, we use the same example 3 times when we studied each of the methods separately. Okay? So we used the Johnson and Johnson and Johnson buying a truck. They spent \$42,000 on the truck, it had a \$2,000 residual value and a 5-year useful life. Okay? So here I've summarized all of the answers that we got from all 3 of those methods. And what you're going to notice is that the total depreciation over the life of the asset, regardless of the method that we used, is going to be the same. Right? If you add up all of these numbers, the straight-line \$8,005 times, well, we get \$40,000 in depreciation, right? \$40,000 in total depreciation over those 5 years. If you add up the double-declining balance numbers, that's also going to equal \$40,000. And I've got a little star here next to the \$3,443 because we rounded that number. That was the plug. Remember that we plug that in to get to our residual value. And that's the trick with the double declining balance that last year, we plug it in. Okay? And then the units of production method, here I've got 2 columns. This left column is the dollar amounts, and this is the miles that the truck was driven on the right, right? So on the right, it shows the units of production. So if we add all of those numbers on the left, we'll see that we got \$40,000 in total depreciation. So no matter what method we use, we get the full \$40,000. The same depreciable base is depreciated over the course of the life of the asset. It just varies in when we take the depreciation. The straight line is easy because it's smooth and we take the same amount every year. The double declining balance is accelerated, and we take more depreciation in the early years and less in the later years. And the units of production, well this one, it just depends on how many miles were driven in each year, right? Or how many units were produced each year. So that one there's not really a oh it's more in the early years, more in the late years. It really just depends on how you use the asset in the units of production method. But the main takeaway with this table is that over the life of the asset, they all take the same total depreciation. Cool? So one more note about depreciation here, is that most companies use the straight-line method. Okay. This is kind of just the go-to method, and everyone just uses it because it's so simple. But what I want to say is that for tax purposes, the IRS permits the use of something similar to the double declining balance. It's an accelerated method. The double declining balance is an accelerated method, and the IRS allows the use of something called the modified accelerated cost recovery system. Very IRS terms there, very technical terms. We call it MACRS for short, but it's another basically accelerated depreciation, very similar to the double declining balance. Okay? So why would a company want to use an accelerated depreciation method for its taxes? Well, let's think about what an accelerated depreciation does in the first few years. So think about it. We just spent a whole ton of money on a fixed asset. We spent hundreds of thousands of dollars buying a machine. Well, what's the benefit to us? Well, if we take this accelerated method, then that means our depreciation expense is going to be higher in those early years, right? Let me use a different color here. I'll use black. So we're going to have higher depreciation expense in those early years. And if we have more expenses, what does that do to our income? Our net income is going to be smaller, right? So the amount of money that we we pay taxes after expenses, right? We get our revenues minus expenses, and then what's left over, we pay taxes on the leftovers. So if we have higher expenses, we have less taxable income. And if we have less taxable income, well, if there's less taxable income then we pay less taxes, okay? So why would why would the IRS want us to do this? Why would the IRS want us to pay less taxes? Well, the IRS itself probably doesn't want us to pay less taxes, but the idea here is that it helps motivate companies to invest and grow their companies. So this is kind of from an economic perspective. This is kind of an incentive for companies to invest in machines and fixed assets. Things that cost a lot of money. It gives them a little extra incentive to spend that money and get this bit of a tax break soon after they spend the money by giving them a little extra depreciation expense. Cool? And remember, since depreciation expense is not a cash expense, you're not paying extra cash for the depreciation expense. Well, the company is not paying extra for this tax benefit. So that's why the IRS allows this modified system. It gives an incentive for investment in these fixed assets and growth of the economy. Cool? Alright. So this is just a summary of everything we've learned in the past few lessons. Let's go ahead and move on to something new.

Here’s what students ask on this topic:

What are the main methods of depreciation?

The main methods of depreciation are the Straight-Line Method, Double Declining Balance Method, and Units of Production Method. The Straight-Line Method spreads the cost evenly over the asset's useful life. The Double Declining Balance Method is an accelerated method that depreciates more in the early years. The Units of Production Method bases depreciation on the asset's usage, such as miles driven or units produced. Each method has its own formula and application, but all aim to allocate the cost of a fixed asset over its useful life.

How is the Straight-Line Method of depreciation calculated?

The Straight-Line Method of depreciation is calculated using the formula:

Cost - Residual ValueUseful Life

This method spreads the cost of the asset evenly over its useful life. For example, if an asset costs $42,000, has a residual value of $2,000, and a useful life of 5 years, the annual depreciation expense would be:

42,000 - 2,0005 = 8,000

What is the Double Declining Balance Method of depreciation?

The Double Declining Balance Method is an accelerated depreciation method. It calculates depreciation by doubling the straight-line depreciation rate and applying it to the asset's book value at the beginning of each year. The formula is:

2 × 1Useful Life × Book Value

This method results in higher depreciation expenses in the early years and lower expenses in the later years. It is useful for assets that lose value quickly.

Why do companies prefer the Straight-Line Method for depreciation?

Companies often prefer the Straight-Line Method for depreciation because it is simple and easy to apply. This method spreads the cost of the asset evenly over its useful life, resulting in consistent annual depreciation expenses. This consistency makes financial planning and reporting straightforward. Additionally, the Straight-Line Method is widely accepted and understood, making it a go-to choice for many companies. While other methods like the Double Declining Balance or Units of Production may offer advantages in specific scenarios, the simplicity and predictability of the Straight-Line Method make it a popular choice.

What is the Modified Accelerated Cost Recovery System (MACRS)?

The Modified Accelerated Cost Recovery System (MACRS) is a depreciation method allowed by the IRS for tax purposes. It is an accelerated depreciation method similar to the Double Declining Balance Method. MACRS allows businesses to depreciate assets more quickly in the early years of the asset's life, resulting in higher depreciation expenses and lower taxable income initially. This provides a tax incentive for companies to invest in new assets by reducing their tax liability in the early years of the asset's use. MACRS is designed to encourage economic growth and investment in capital assets.