Appreciation for Depreciation
Do you have it?
Author: Dennis Hallett 10/23/2009
Congratulations, you just bought a new truck for your landscaping business. You will now be more efficient because you no longer have to travel back and forth to get your tools to the job site. This new asset will take your business to the next level and you can now compete for those large jobs the competition gets every day. The question is, “how do you account for this large expense in your financial statements to your investors and your tax returns?” Depreciation is the accounting tool that allows you to account for the cost of this new asset.
Depreciation is an application of the matching principle. The purchase or buildings and equipment are recorded at their original cost. In our example, the new landscaping truck costs $30K, but the financial benefit from this new vehicle will not be realized until future jobs are earned. Therefore it is necessary to come up with some correlation between this expensive asset and the future economic benefit it brings to the company. Depreciation is that correlation. At face value, some think depreciation is just a recalculation of the new market value of an asset. This is not the case; depreciation applies a portion of that initial expense to the revenue earned for a given period of time. We will explore this relationship and how they are applied through straight-line depreciation and accelerated depreciation.
Straight-line depreciation takes the total cost of an asset, in our case $30K for the new truck, and divides it by the years of life for that asset. The straight-line depreciation method is most often used for reporting to stockholders because in early years it accounts for lower depreciation expense and therefore maximizes the revenue for that period. In our example, the trucks useful life is 10 years so we would take $30K and divide by 10 years to come up with yearly depreciation of $3K. During every fiscal year $3K would be applied to the income statement as an expense and reduce net income by $3K.
There are multiple forms of accelerated depreciation, for our example we will focus on declining balance. Different than straight-line depreciation, double declining balance maximizes the depreciation in the early years having a negative effect on net income. Most firms do not use this for their financial accounting methods, but in turn use it for tax accounting methods. Maximizing a company’s expense early will help reduce a company’s tax burden. The reason for not using this method for the income statement is because it reduces the early net income for a company skewing a company’s financial performance.
In our example the trucks useful life is still 10 years, but the depreciation rate is doubled. The straight-line depreciation rate is 10% (1/10 years), so for double declining depreciation we will double the 10% depreciation rate to 20%. Therefore, the first year’s depreciation expense will now be $6K. The second year’s depreciation expense will be $4.8K. How do we come up with the second year’s depreciation? Subtract the first year’s depreciation of $6K from the total expense of $30K to come up with the new book value of $24K. This new book value is then multiplied by the depreciation rate of 20% for a total of $4.8K. $4.8K is then subtracted from $24K to come up with the new book value of 19.2K. This continues until the salvage value of the truck is reached.
From the above examples you can see that straight-line depreciation provides the lowest early depreciation expense of $3K and declining-balance depreciation provides the largest early depreciation expense of $6K. To maximize a company’s net income it is best to select the method providing the least depreciation. To minimize a company’s tax burden it is best to select the method providing the greatest depreciation.
The question often raised with declining-balance depreciation is; "what happens in future years?" The answer is twofold, all firms want to maximize the dollars received today, just like you would prefer a dollar today versus a dollar 10 years in the future and secondly firms continually add equipment to their assets as they grow so the declining depreciation is offset by the addition of these new assets. As you can see the accounting methods for depreciation differ greatly depending upon a company’s goal.
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