Depreciation is a central concept in accounting and is based on the central principle of accrual accounting: the matching principle. In depreciation, the cost of non-current assets (or those assets that last more than one year) is distributed over an estimate of the useful life of the asset. This is done to follow the matching principle, which states that expenses must match the income they helped create over a period of time. For example, if a company builds a new factory for $1 million with a useful life of 10 years, it cannot put $1 million on its balance sheets right away; they have to depreciate it to match a part of the factory with the income you helped create over a period of time. They would have to show $100,000 for 10 years ($1 million / 10 years).
There are many different ways that companies calculate depreciation. The two types of methods are the straight-line depreciation method and the accelerated depreciation methods. It is important to note that a business could legally use one depreciation method for financial accounting purposes and another for tax purposes, why they would want to do this will be explained shortly. First, it is necessary to explain how the methods differ. Straight-line depreciation is calculated by taking the purchase price, subtracting the residual value of the asset (this is an estimate of how much the asset will be worth at the end of its useful life), and then dividing by its useful life. To illustrate this we can consider the previous example. If the salvage value of the factory is $75,000, then we would take ($1 million – $75,000) / 10 = $92,500. The asset could depreciate annually to this amount. This means that the asset will depreciate at a rate of 9.25% per year.
Accelerated depreciation methods give a higher depreciation expense in the early years of an asset’s useful life and a lower expense later. Businesses often use accelerated depreciation methods so they can write off more of the asset sooner, instead of receiving less money over a longer period of time.
One of these methods is known as 200% or double declining balance depreciation. This method first takes the 200% straight-line depreciation rate and then, halfway through the asset’s estimated useful life, switches back to straight-line depreciation. Using the example above, 200% is multiplied by 9.25% to give a straight-line depreciation rate of 18.5%. Therefore, in the first year we would multiply $1 million by 18.5% to get a depreciation of $185,000. We would then take the remaining total and depreciate it at the same rate. So $1 million – $185,000 = $815,000. We would take this amount and depreciate it at a rate of 18.5% to get $150,775 (this amount will depreciate in the second year). This process continues until the middle of the useful life of the asset or in this case the sixth year. In that year, the remaining balance would be converted to straight-line depreciation by taking the remaining amount to be depreciated and dividing it by 5 (for the remaining years).
Another frequently used accelerated depreciation method is the Modified Accelerated Cost Recovery System, or MACRS. This system was implemented as part of the US Tax Reform Act of 1986 and took effect for assets placed in service after 1986. This method divides fixed assets into classes and defines their useful lives and depreciation periods. using the double declining balance method. The intent of MACRS is to enable asset owners to expedite their asset write-offs for tax purposes.
To make it easier to record different purchase dates in a year, the MACRS method uses a half-year convention. No matter when the asset is purchased in a fiscal year, a company can depreciate half a year’s worth of the asset.
Thus, depreciation for an asset with a useful life of 7 years is reported in 8 years, half a year in the first year, then 6 years, and then another half year in the eighth year.
In this method, assets are placed into categories of classes that have 3, 5, 7, 10, 15, and 20 years of depreciation with the Internal Revenue Service (IRS) specifying which assets are placed in which class. Calculations use the double declining balance method. This uses depreciation, which is double depreciation in a straight line. Under straight-line depreciation, an asset with a useful life of seven years depreciates 14.29% each year. In MACRS depreciation, the first year depreciation is 28.58% (but it only amounts to 14.29% since the half-year convention is used). The second year takes the remaining 85.71% (the total subtracts 14.29%) and depreciates it by 28.58% (or 24.49% of the original). This procedure continues for the next 6 years, then half a year in the last year.
Depreciation of assets is an important part of the accounting process. You try to smooth the flow of income by dividing non-current assets over a period of time, that is, using the matching principle to match expenses with the income you helped create in the same period.