The basic theory of depreciation accounting is unarguable: The amount of capital a business invests in a fixed asset, less its estimated future residual (salvage) 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 shouldn’t 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.
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. The IRS publication “How To Depreciate Property” (2005 edition) runs 112 pages. You ought to read this pamphlet— if you have the time.
The depreciation provisions in the income tax [IRS’s] 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 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.
Let’s assume a 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:
Plus: Building $468,000
Plus: Machines $532,000
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.
The question is: what depreciation amounts for the year should be recorded on the business’s building and machines?
Under the federal income tax law, the cost of a building used by a business in its operations is depreciated over 39 years by the straight-line depreciation method of allocation. Therefore, the depreciation on the building for the year equals $12,000 [Note: $468,000 cost / 39 years = $12,000 depreciation per year].
Under the federal [USA] income tax law, the machines used by the business fall into the seven-year useful life class, and they can be (but don’t have to be) depreciated by the double-declining balance method of allocation. This is an accelerated depreciation method of allocation that front-loads depreciation, which means that more depreciation is allocated to the early years and less to the later years of the asset’s useful life.
Let’s say if the applicable percent for the first year is double the straight-line rate. Therefore, 2/7 of the cost of the machines is charged to depreciation in the first year: $532,000 × 2/7 = $152,000 depreciation in the first year.
In years two, three, and four, the percent is the same but is applied on the declining balance, which equals cost less accumulated depreciation at the start of the year. So, for example, in the second year, 2/7 is multiplied by the original cost of the machines minus the first year’s depreciation. The business converts to the straight-line depreciation method for the last three years. In these three years, the straight-line depreciation amount is higher on the declining balance than the amount determined by the accelerated rate. By switching to the straight-line depreciation method for the last three years, the original cost of the machines is fully depreciated over the seven-year life of the assets. [Cost wouldn’t be fully depreciated if the accelerated rate were used in the last three years].