Depreciation Methods

Why This Matters

Depreciation isn't just about spreading costs across time—it's about understanding how accounting choices shape financial statements, tax liabilities, and business decision-making. You're being tested on your ability to recognize why a company would choose one method over another, how each method affects the income statement and balance sheet differently, and what happens when book depreciation diverges from tax depreciation. These concepts connect directly to asset valuation, expense recognition, and the matching principle.

Don't just memorize formulas—know what each method reveals about an asset's economic reality. Can you explain why an accelerated method front-loads expenses? Can you identify which method best matches revenue generation for a delivery truck versus office furniture? Master the underlying logic, and you'll handle any calculation or conceptual question the exam throws at you.

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Straight-Line Methods: Even Allocation Over Time

The simplest approach assumes an asset provides equal benefit each period. The underlying principle is that depreciation expense should remain constant when utility doesn't decline significantly over time.

Straight-Line Method

• Formula: $(Cost - Salvage Value) \div Useful Life$—produces identical expense each period, making budgeting and forecasting straightforward
• Best for assets with uniform utility, such as buildings or office furniture that don't lose effectiveness as they age
• Most common GAAP method for financial reporting due to its simplicity and conservative, predictable expense pattern

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Accelerated Methods: Front-Loading Depreciation

These methods recognize higher expenses early in an asset's life, reflecting the reality that many assets lose value—or become obsolete—faster in their initial years. The mechanism here is matching: if an asset generates more revenue or utility early on, expenses should follow.

Declining Balance Method

• Formula: $Book Value \times Depreciation Rate$—applies a fixed percentage to the remaining book value each year
• Higher early expenses, lower later expenses reflect the decreasing utility of technology, vehicles, and equipment that wear out or become outdated
• Tax advantage comes from maximizing deductions when the asset is newest and generating the most revenue

Double Declining Balance Method

• Formula: $(2 \div Useful Life) \times Book Value$—doubles the straight-line rate for aggressive acceleration
• Never deducts salvage value in the formula, though you must stop depreciating once book value equals salvage value
• Ideal for rapidly depreciating assets like computers or specialized equipment where obsolescence is a major factor

Sum-of-the-Years'-Digits Method

• Formula: $(Remaining Life \div SYD) \times (Cost - Salvage Value)$—where SYD for a 5-year asset equals $1+2+3+4+5=15$
• Depreciation decreases by a predictable amount each year, unlike declining balance where the decrease varies
• Applies to depreciable base (cost minus salvage), distinguishing it from declining balance methods that ignore salvage value in calculations

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Activity-Based Methods: Matching Usage to Expense

When an asset's wear correlates with how much it's used rather than how long it's owned, time-based methods fail. Activity-based depreciation ties expense directly to output, aligning with the matching principle.

Units of Production Method

• Formula: $\frac{Cost - Salvage Value}{Total Estimated Units} \times Units Produced$—expense varies with actual usage each period
• Variable expense matches variable revenue, making this ideal for manufacturing equipment, delivery vehicles, or mining assets
• Requires reliable usage estimates; if total units are miscalculated, depreciation expense becomes inaccurate across all periods

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Tax Depreciation: MACRS and Compliance

For U.S. tax purposes, companies don't get to choose freely—the IRS mandates specific depreciation rules that often differ from GAAP.

Modified Accelerated Cost Recovery System (MACRS)

• Required for U.S. tax reporting—uses predetermined recovery periods (3, 5, 7, 15, or 39 years) and IRS-published depreciation tables
• Ignores salvage value entirely, allowing full cost recovery and larger total deductions than GAAP methods
• Creates book-tax differences that must be tracked; these temporary differences affect deferred tax assets and liabilities on the balance sheet

Depreciation for Tax vs. Financial Reporting

• GAAP prioritizes faithful representation of economic reality, often using straight-line; tax rules prioritize incentivizing investment through acceleration
• Temporary differences arise when tax depreciation exceeds book depreciation early, then reverses in later years
• Deferred tax liabilities result when taxable income is lower than book income due to accelerated tax depreciation—expect this on exams

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Group and Composite Methods: Simplifying Large Asset Pools

When tracking individual assets becomes impractical, accountants combine them. These methods sacrifice precision for efficiency, applying a single rate to an entire group.

Composite Depreciation Method

• Groups similar assets (same type, varying lives) under one depreciation rate calculated from the weighted average
• No gain or loss on disposal—proceeds reduce the accumulated depreciation account rather than hitting the income statement
• Simplifies record-keeping for companies with hundreds of similar items like furniture, fixtures, or tools

Group Depreciation Method

• Groups dissimilar assets managed together, using an average useful life to determine the rate
• Same disposal treatment as composite—eliminates individual tracking of gains and losses
• Best for low-cost, high-volume assets where individual depreciation calculations would be administratively burdensome

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Special Considerations: Partial-Year Depreciation

Assets rarely arrive on January 1st. Partial-year conventions ensure depreciation reflects actual time in service.

Partial-Year Depreciation

• Prorate based on months in service—if acquired in April, only 9/12 of annual depreciation applies in year one
• Common conventions include half-year and mid-month; MACRS typically uses half-year unless the asset qualifies for mid-quarter
• Affects both acquisition and disposal years—the year you sell an asset also requires prorated depreciation through the disposal date

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Quick Reference Table

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Self-Check Questions

1. Which two methods apply a depreciation rate to book value rather than depreciable base, and how do their rates differ?

2. A manufacturing company has equipment that runs heavily in Q1 and Q4 but sits idle in summer. Which depreciation method best matches expense to revenue, and why would straight-line misrepresent economic reality?

3. Compare and contrast MACRS and straight-line depreciation: how does each treat salvage value, and what financial statement impact results from using different methods for tax versus book purposes?

4. If an asset is purchased on October 1st and the company uses straight-line depreciation, how would you calculate first-year depreciation, and why does this matter for accurate expense recognition?

5. A company disposes of an asset accounted for under the composite method. How is the disposal recorded differently than under individual asset depreciation, and why might this affect reported income?