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Alternative types of Depreciation and the Time Value of Money

Many people are familiar with the term depreciation, but what does it really mean?  Depreciation in the accounting sense is the process by which a firm stretches out the cost of a non-current asset over several periods.  Non-current assets can be defined as plant, property, or equipment which has a useful life of more than one year.  There are many methods of depreciating an asset.  We will focus on two, Straight Line and Double Declining Balance, and how they affect the balance sheet.

Straight Line Depreciation is a simple calculation.  The formula is:  Annual Depreciation = Cost – Estimated Salvage Value ÷ Useful Years.  Here is a simple example.  If an asset cost $50,000 and has a salvage value of $5,000, with a useful life of five years, the firm will take $9,000 per year depreciation.  $9,000 per year = $50,000 – $5,000 ÷ 5 Years.  The advantage of Straight Line Depreciation is a firm can account for the amount of “use” of an asset during the period in which the revenue was earned. 

The Double Declining Balance calculation accelerates the amount of depreciation in the early years of an asset life vs. Straight Line Depreciation.  With Double Declining Balance the Straight Line Depreciation rate is doubled and deducted from the book value at the beginning of each year.  Keeping with our example, if an asset has a life of five years the Straight Line Deprecation rate would be 20% or 1year ÷ 5years, which would make the Double Declining Balance rate 40%.  During the midpoint of the depreciating assets’ life span the calculation switches to the Straight Line method.  If the switch to Straight Line did not occur, the asset would never be fully depreciated using Double Declining Balance.  The salvage value is not deducted until the end of the depreciation.  Still keeping with the same numbers in our Straight Line Depreciation example, the first year of depreciation the firm would depreciate $20,000 instead of the $9,000 under Straight Line Depreciation.  The next four years the firm would depreciate a declining amount each year of $12,000, $7,200, $4320, and $1480 respectively. 

Comparing the two methods of depreciation one can see that Double Declining Balance allows for greater depreciation during the first few years, compared to Single Line Depreciation.   Some firms may use two different methods of depreciation depending on who the audience of the depreciation reporting will be.  One reason a financial report for investors or managers would use Straight Line Depreciation is Straight Line Depreciation allows the managers to spread the cost of the asset evenly over the life of the asset.  Using Straight Line Depreciation the firm will not depreciate as much of the asset in the early years as with Double Declining Depreciation.  This means less depreciation is expensed in the early years, which would mean the income will not be reduced as much with Straight Line Depreciation verses Double Declining Depreciation.   

When reporting to the Internal Revenue Service (IRS), a firm would want to use the Double Declining method.  What is the reason is the firm would want to reduce the amount of reported income in the early years of an asset purchase?  By increasing the depreciation of the asset, the firm will report less net income and the firm can reduce their tax liability in the early years.   Another added benefit to Double Declining Balance is it may more clearly reflect the loss in value of the asset during the early years, if we assume the greatest loss of the value of an asset is early in its’ useful life.

Even though there is less tax liability in the early years with Double Declining Depreciation, the tax liability would be more in the later years vs. using Straight Line Depreciation.  A firm should still chose to do this because of the time value of money.  Instead of sending income to the IRS, the firm can use it to fund their own operations.  It is assumed the firm can make better use of the capital today, rather than sending it away in taxes.  If a firm is generating income on its’ own capital, they are much better off holding onto their own money.  Paying the taxes today instead of later, would in effect be giving an interest free loan to the IRS.   Another fact to consider is the effect of inflation.  A dollar today has more purchasing power today than a dollar will in five years from now.  Because of the time value of money, a firm should put as many dollars to work today as they can instead of waiting until a later date.

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