Which of the following statements about depreciation methods is not correct?

Financial statements and the ratios derived from them may be significantly impacted by a company’s selected depreciation method and accompanying assumptions and estimates.

Companies should review the estimates used periodically to ensure that they remain reasonable.

The Effect of the Choice of Depreciation Method and Assumptions on Depreciation Expense, Financial Statements, and Financial Ratios

The choice of depreciation method will affect the amounts that are reported on the financial statements, including the amounts for reported assets and operating and net income. Several financial ratios will be affected because of this. Among others, the fixed asset turnover, total asset turnover, operating profit margin, operating return on assets, and return on assets will be affected.

In some countries, the same depreciation method is not used for financial reporting and tax purposes. As a result, pre-tax income on the income statement and taxable income on the tax return are likely to differ. The amount of tax expense computed based on pre-tax income and the amount of taxes actually owed based on taxable income may be different.

For example, a company may use the straight-line method of depreciation for financial reporting and an accelerated depreciation method for tax purposes.  In such an instance, the company’s financial statements will report lower depreciation expense and higher pre-tax income in the first year, compared with the amount of depreciation expense and taxable income in its tax reporting. The tax expense that is calculated based on the financial statements’ pre-tax income will be higher than taxes payable based on taxable income. The difference between the two amounts is a deferred tax liability. This deferred tax liability will be reduced as the difference reverses, i.e., when the depreciation for financial reporting becomes higher than the depreciation for tax purposes and the income tax is paid.

Significant estimates are required for calculating depreciation expenses. These include the useful life of an asset and the expected residual value at the end of that useful life. Longer useful life and a higher expected residual value will decrease the amount of annual depreciation expense relative to a shorter useful life and lower expected residual value.

Question 1

Companies A and B purchase a similar machine at the same time and at the same cost. In reporting this acquisition, company A uses the straight-line method of depreciation, while company B uses the double declining balance method. Other than the choice of depreciation method, both companies use similar estimates and assumptions.

Assuming that the machine is the only long-lived asset that both companies report on their financial statements, which of the following statements is the most accurate?

1. Company A and B will have the same tax expense.
2. Company A will have a higher pre-tax income in the first year, than company B.
3. Company A will have a higher depreciation expense in the first year than company B.

Solution

The correct answer is B.

Company A will have a higher pre-tax income in the first year than company B because of its lower depreciation expense under the straight-line method of depreciation.

A is incorrect because company A will have a lower depreciation expense.

C is incorrect because company A will have a higher tax expense in the first year due to its higher pre-tax income.

Question 2

How would an increase in the estimated residual value of an asset affect a company’s net income?

1. It has no effect.
2. It would increase net income.
3. It would decrease net income.

Solution

The correct answer is B.

Increasing the residual value would decrease the annual depreciation expense of the asset. Decreasing the depreciation expense of the asset would therefore increase net income.

Depreciation accounts for decreases in the value of a company’s assets over time. In the United States, accountants must adhere to generally accepted accounting principles (GAAP) in calculating and reporting depreciation on financial statements. GAAP is a set of rules that includes the details, complexities, and legalities of business and corporate accounting. GAAP guidelines highlight several separate, allowable methods of depreciation that accounting professionals may use.

Key Takeaways:

• Depreciation accounts for decreases in the value of a company’s assets over time.
• Depreciation allows a business to deduct the cost of an asset over time rather than all at once.
• Accountants adhere to generally accepted accounting principles (GAAP) to calculate depreciation.
• The four methods for calculating depreciation allowable under GAAP include straight-line, declining balance, sum-of-the-years' digits, and units of production.
• The best method for a business depends on size and industry, accounting needs, and types of assets purchased.

Methods of Depreciation

The four depreciation methods include straight-line, declining balance, sum-of-the-years' digits, and units of production.

Straight-Line Depreciation

The straight-line method is the most common and simplest to use. A company estimates an asset's useful life and salvage value (scrap value) at the end of its life. Depreciation determined by this method must be expensed in each year of the asset's estimated lifespan.

Tip

This formula is best for small businesses seeking a simple method of depreciation.

Depreciation: (cost of asset - salvage value)/useful life

Declining Balance Depreciation

The declining balance method is a type of accelerated depreciation used to write off depreciation costs earlier in an asset's life and to minimize tax exposure. With this method, fixed assets depreciate more so early in life rather than evenly over their entire estimated useful life.

This method is often used if an asset is expected to lose greater value or have greater utility in earlier years. It also helps to create a larger realized gain when the asset is sold. Some companies may use the double-declining balance equation for more aggressive depreciation and early expense management.

Tip

This formula is best for companies with assets that lose greater value in the early years and that want larger depreciation deductions sooner.

Depreciation: current book value x depreciation rate

Sum-of-the-Years' Digits Depreciation

The sum-of-the-years'-digits method (SYD) accelerates depreciation as well but less aggressively than the declining balance method. Annual depreciation is derived using the total of the number of years of the asset's useful life. The SYD depreciation equation is more appropriate than the straight-line calculation if an asset loses value more quickly, or has a greater production capacity, during its earlier years.

Tip

This formula is best for companies with assets that will lose more value in the early years and that want to capture write-offs that are more evenly distributed than those determined with the declining balance method.

Depreciation: (remaining lifespan/SYD) x (asset cost - salvage value)

Units of Production Depreciation

The units of production method assigns an equal expense rate to each unit produced. It's most useful where an asset's value lies in the number of units it produces or in how much it's used, rather than in its lifespan. The formula determines the expense for the accounting period multiplied by the number of units produced.

Tip

This formula is best for production-focused businesses with asset output that fluctuates due to demand.

Depreciation: (asset cost - salvage value)/estimated units over asset's lifetime x actual units made

Examples

Let's say, ABC company purchases machinery for $25,000. This asset's salvage value is $500 and its useful life is 10 years. The examples below demonstrate how the formula for each depreciation method would work and how the company would benefit.

Calculating Depreciation Using the Straight-Line Method

Formula: (cost of asset-salvage value)/useful life

Method in action: ($25,000 - $500)/10 = $2,450

Result: ABC's yearly tax deduction is $2,450 over the life of the asset.

Calculating Depreciation Using the Declining Balance Method

Formula: current book value x depreciation rate

Method in action: $25,000 x 30% = $7,500

Result: ABC's depreciation amount in the first year is $7,500. In the second year, the current book value would be $17,500 ($25,000 - $7,500). So, the depreciation amount would be $5,250 ($17,500 x 30%). And so on.

Calculating Depreciation Using the Sum-of-the-Years' Digits Method

Formula: (remaining lifespan/SYD) x (asset cost - salvage value) where SYD equals the total of all the years in the lifespan

Method in action: SYD = 55 (1+2+3+4+5+6+7+8+9+10); (10/55) x ($25,000 - $500) = $4,454

Result: in the first year, ABC can deduct $4,454 in depreciation expense. In the second year, the deduction would be $4,009 ((9/55) x $24,500). And so on.

Calculating Depreciation Using the Units of Production Method

Formula: (asset cost - salvage value)/estimated units over asset's life x actual units made

Method in action: ($25,000 - 500)/50,000 x 5,000 = $2,450

Result: ABC's depreciation expense is $2,450 for the year. This method will produce results that vary annually depending on the number of units made.

Special Considerations

Companies have several options for depreciating the value of assets over time, in accordance with GAAP. Most companies use a single depreciation methodology for all of their assets. Thus, the methods used in calculating depreciation are typically industry-specific.

What Is Depreciation?

Depreciation is an accounting method that companies use to apportion the cost of capital investments with long lives, such as real estate and machinery. Depreciation reduces the value of these assets on a company's balance sheet.

How Do You Calculate Depreciation Annually?

There are various ways of calculating depreciation. To start, a company must know an asset's cost, useful life, and salvage value. Then, it can calculate depreciation using a method suited to its accounting needs, asset type, asset lifespan, or the number of units produced.

What Does Depreciation Tell You?

Depreciation calculations determine the portion of an asset's cost that can be deducted in a given year. Depending on the method used, the amount may be the same every year. Or, it may be larger in earlier years and decline annually over the life of the asset.

Which of the following is NOT depreciation method?

Answer and Explanation: A) total cost is not an acceptable method of depreciation.

Which of the following is not true for depreciation?

depreciation expense does not measure changes in market value.

Which of the following statements is correct about depreciation?

The correct answer is option c) Depreciation represents the allocation of the cost of a capital asset over its life based on a specific method of...

Which of the following is not a depreciation method of fixed assets?

Land, although a fixed asset is never depreciable. It has an unlimited useful life and therefore can not be depreciated. Depreciation is allocation of cost of fixed asset over its useful life. Value of land can not be reduced to zero and it can not be allocated over its useful life.