7.5. Appreciating Depreciation Methods

In theory, depreciation expense accounting is straightforward enough: You divide the cost of a fixed asset (except land) among the number of years that the business expects to use the asset. In other words, instead of having a huge lump-sum expense in the year that you make the purchase, you charge a fraction of the cost to expense for each year of the asset's lifetime. Using this method is much easier on your bottom line in the year of purchase, of course.

Theories are rarely as simple in real life as they are on paper, and this one is no exception. Do you divide the cost evenly across the asset's lifetime, or do you charge more to certain years than others? Furthermore, when it eventually comes time to dispose of fixed assets, the assets may have some disposable, or salvage, value. In theory, only cost minus the salvage value should be depreciated. But in actual practice most companies ignore salvage value and the total cost of a fixed asset is depreciated. Moreover, how do you estimate how long an asset will last in the first place? Do you consult an accountant psychic hot line?

As it turns out, the IRS runs its own little psychic business on the side, with a crystal ball known as the Internal Revenue Code. Okay, so the IRS can't tell you that your truck is going to conk out in five years, seven months, and two days. The Internal Revenue Code doesn't give you predictions of how long your fixed assets will last; it only tells you what kind of time line to use for income tax purposes, as well as how to divide the cost along that time line.

Note: The tax law can change at any time, and you can count on the tax law to be extremely technical. The following discussion is meant only as a basic introduction and certainly not as tax advice. The annual income tax guides, such as Taxes For Dummies by Eric Tyson, Margaret Atkins Munro, and David J. Silverman (Wiley), go into the more technical details of calculating depreciation.

The IRS rules offer two depreciation methods that can be used for particular classes of assets. Buildings must be depreciated just one way, but for other fixed assets you can take your pick:

• Straight-line depreciation: With this method, you divide the cost evenly among the years of the asset's estimated lifetime. Buildings have to be depreciated this way. Assume that a building purchased by a business cost $390,000, and its useful life — according to the tax law — is 39 years. The depreciation expense is $10,000 (1/39 of the cost) for each of the 39 years. You may choose to use the straight-line method for other types of assets. After you start using this method for a particular asset, you can't change your mind and switch to another depreciation method later.

• Accelerated depreciation: Actually, this term is a generic catchall for several different kinds of methods. What they all have in common is that they're front-loading methods, meaning that you charge a larger amount of depreciation expense in the early years and a smaller amount in the later years. The term accelerated also refers to adopting useful lives that are shorter than realistic estimates. (Very few automobiles are useless after five years, for example, but they can be fully depreciated over five years for income tax purposes.)

  One popular accelerated method is the double-declining balance (DDB) depreciation method. With this method, you calculate the straight-line depreciation rate, and then you double that percentage. You apply that doubled percentage to the declining balance over the course of the asset's depreciation time line. After a certain number of years, you switch back to the straight-line method to ensure that you depreciate the full cost by the end of the predetermined number of years.

Fully depreciated fixed assets are grouped with all other fixed assets in external balance sheets. All these long-term resources of a business are reported in one asset account called property, plant, and equipment (usually not "fixed assets"). If all its fixed assets were fully depreciated, the balance sheet of a company would look rather peculiar — the cost of its fixed assets would be offset by its accumulated depreciation. Keep in mind that the cost of land (as opposed to the structures on the land) is not depreciated. The original cost of land stays on the books as long as the business owns the property.

The straight-line depreciation method has strong advantages: It's easy to understand, and it stabilizes the depreciation expense from year to year. Nevertheless, many business managers and accountants favor an accelerated depreciation method in order to minimize the size of the checks they have to write to the IRS in the early years of using fixed assets. This lets the business keep the cash, for the time being, instead of paying more income tax. Keep in mind, however, that the depreciation expense in the annual income statement is higher in the early years when you use an accelerated depreciation method, and so bottom-line profit is lower. Many accountants and businesses like accelerated depreciation because it paints a more conservative (a lower or more moderate) picture of profit performance in the early years. Who knows? Fixed assets may lose their economic usefulness to a business sooner than expected. If this happens, using the accelerated depreciation method would look very wise in hindsight.