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Wednesday, July 13, 2011

Depreciation Accounting Methods

The basic theory of depreciation accounting is unarguable: The amount of capital a business
invests in a fixed asset, less its estimated future residual value when it will be disposed
of, should be allocated in a rational and systematic manner over its estimated useful
life to the business.

A fixed asset’s cost should not be charged entirely to expense in the year the asset’s acquired.
Doing so would heavily penalize the year of acquisition and relieve future years from any
share of the cost. But the opposite approach is equally bad: The business shouldn’t wait
until a fixed asset is eventually disposed of to record the expense of using the asset. Doing so
would heavily penalize the final year and relieve earlier years from any share of the fixed
asset’s cost.

Essentially, cost less residual value should be apportioned to every year of the fixed asset’s
use. (Land has perpetual life, and therefore, its cost isn’t depreciated.) The theory of depreciation is relatively simple, but the devil is in the details. And, I mean details!

Frankly, there’s not much point in discussing the finer points of depreciation accounting. I
could refer you to many books written by accounting scholars on depreciation. But as a practical
matter the federal income tax law dictates the depreciation methods and practices used
by most businesses.

Let me step on the soapbox for a moment. The depreciation provisions in the income tax law
are driven mainly by political and economic incentives, to encourage businesses to upgrade
and modernize their investments in long-term operating assets. By and large, businesses
follow income tax regulations on depreciation. As the result, useful lives for depreciating
fixed assets are too short, salvage value is generally ignored, and depreciation is stacked
higher in the early years. In other words: fixed assets generally last longer than their income
tax depreciation lives; when disposed of fixed assets often have some salvage value; and, a
strong case can be made for allocating an equal amount of depreciation to each year over the
useful life of many fixed assets. In short, actual depreciation practices deviate from depreciation
theory. Okay, I’m off my soapbox now.

No depreciation expense for the year has been recorded yet, but obviously, some amount of
depreciation must be recorded. The business purchased all its fixed assets during the first
week of the year, and the assets were placed in service immediately, so the business is entitled
to record a full year’s depreciation on its fixed assets. (Special partial-year rules apply
when assets are placed in service at other times during the year.)

The company’s plant, property, and equipment account consists of the following components:

Land $150,000
Building $468,000
Machines $532,000
Total $1,150,000

The cost of land is not depreciated. Land stays on the books at original cost as long as the
business owns the land. Ownership of land is a right in perpetuity, which does not come to
an end. Land does not wear out in the physical sense, and generally holds its economic value
over time. Buildings, machines and other fixed assets, on the other hand, wear out with use
over time and generally reach a point where they have no economic value.

Assume the business decides to maximize the amount of depreciation recorded in the year,
according to the provisions of the income tax law.

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