To illustrate the double-declining-balance method, consider our example of the $17,000 delivery truck. The estimated useful life is 5 years; therefore, the straight-line depreciation rate is 20% (l -;-5 years). Doubling this straight-line rate indicates an accelerated depreciation rate of 40%. Each year, we will recognize as depreciation expense 40% of the truck’s current book value, as follows:
Now assume that .we wanted to depreciate this truck using 150% of the straight-line rate..In this case, the depreciation rate will be 30%, instead of 40% (a 20% straight-line rate X 150% = 30%). The depreciation schedule appears as follows:
Notice that we switched to straight-line depreciation in the last 2 years. The undepreciated cost of the truck at the end of Year 3 was $5,831. To depreciate the truck to an estimated residual value of $2,000 at the end of Year 5. $3,831 in depreciation expense must be recognized over the next 2 years. At this point. larger depreciation charges can be recognized if we simply allocate this $3,831 by the straight-line method, rather than continuing to compute 30% of the remaining book value. (In our table, we round the allocation of this amount to the nearest dollar.)
Allocating the remaining book value over the remaining life by the straight-line method does not represent a change in depreciation methods, Rather, a switch to straight line when this will result in larger depreciation is part of the declining-balance method. This is the way in which we arrive at the desired residual value
Actually,taxpayers need not compute MACRS depreciation using the declining balance methods. The Internal Revenue Service publishes depreciation rate tables that show the percentage of cost that may be deducted in each year of the recovery period. These tables automatically apply the half-year convention and switch to straight-line in the appropriate year to maximize the taxpayer’s deduction for depreciation. A MACRS depreciation rate table for all recovery periods up to 20 years appears below
The percentage of the asset’s cost that can be deducted in the first year is relatively . small, reflecting the half-year convention. After the first year, the percentages start out relatively high and then decline-the basic characteristic of an accelerated depreciation
Computing Depreciation for Income Tax Purposes An Illustration
To illustrate the use of the rate table. let us consider our example of S&G Grocery’s delivery truck, which cost S17.000. (For tax purposes. we will disregard the $2.000 residual value.) Under cur-· rent tax0 rules. light-duty trucks arc considered 5-year property.” The depreciation expense that may be deducted in the federal income tax return each year is determined as follows
The benefits of using an accelerated method for income tax purposes are real. because the amount of depreciation claimed affects the amount of taxes owed. Lower income taxes translate directly into increased cash availability.
Financial Statement Disclosures
A company should disclose in. notes to its financial statements the methods used to depreciate plant assets. Readers of the statements should recognize that accelerated depreciation methods transfer the costs of plant assets to expense more quickly than the straight-line method. Thus accelerated methods result in more conservative (lower) balance sheet valuations of plant assets. and·measurements of net income.
The Principle of Consistency
The consistent application of accounting methods is a generally accepted accounting principle. With respecl to depreciation methods, this principle means that a company should not change from year to year the method used in computing the depreciation expense for a given plant asset. However, management may use different methods in computing depreciation for different assets. Also, as we have stressed repeatedly, a company may-and often must-use different depreciation methods in its financial statements and income tax returns
Revision of Estimated Useful Lives
What should be done if, after a few years of using a plant asset, management decides that the asset actually is going to last for a ‘considerably longer or shorter period than was originally estimated? When this situation arises, a revised estimate of useful life should be made and the periodic depreciation expense decreased or increased accordingly.
The procedure for correcting the depreciation program is to spread the remaining undepreciated cost of the asset over the years of remaining useful life. This correction affects only the amount of depreciation expense that will be recorded in the current and future periods. The financial statements of past periods are not revised to reflect changes in the estimated useful lives of depreciable assets,
At the beginning of the fourth’ year, it is decided that the asset will last for 5 more years. The revised estimate of useful life is, therefore, a total of 8 years. The depreciation expense to be recognized for the fourth year and for each of the remaining years is
$800, computed as follows
The Impairment of Plant Assets
0:1 occasion. it may become apparent that a company cannot reasonably expect to recover the cost of certain plant assets, either through use or through sale. For example. a computer manufacturer may have paid a very high price to acquire specialized’ production equipment. If new technology soon renders the equipment obsolete, however. it may become apparent that it is worth far less than its cost