[Accounting] Comparison of depreciation methods
I am an engineering student taking a process economics course and we're covering depreciation.
After covering straight-line (SL) and double declining (DD) depreciation, my professor said that we can compare the two methods to see which one is "better" and went through some algebra to show that SL is better than DD. I guess "better" in this context means which one is more profitable after taking interest into account.
I'm not sure how he came to that conclusion. I have an example where a plant has a 7 year lifespan at a fixed capital investment of $150 and a salvage of $10. Depreciation is $20/y assuming SL and I made a table of values for DD using the different book values. The last year's value of depreciation for DD is adjusted so that the book value is equal to the salvage. I am confident my numbers are correct.
To compare both methods at the end of the lifespan, I treated the SL amount as an annuity over the seven years (with n = 6 since I assumed depreciation is made at end of year) and got $154. Then I individually summed the DD depreciation over the years alongside the interest they generated and got $210.
I'm not sure if my method is wrong or if I'm not interpreting my results correctly. I am thinking that since depreciation is something you can claim as an expense for taxes, if SL is better, then the number I would get for it would be higher than DD. Sorry for long-ish post.
Posted Oct 16, 2016, 10:11 PM UTC
So, I'm a CPA and can say with confidence that there is no "better" depreciation method. It really depends on what the aim is for your financial statements. Most of the time, DD is considered better because the company can expense more of the cost of the item earlier (and therefore reduce net/taxable income and pay less in tax); however, some companies seek to show higher net income and would choose to use straight line depreciation. It depends on what the company wants their financial statements to show.
That being said, I'm not really sure how interest is being taken into account in your problem. Interest would only apply to the loan used to purchase the item in question but is not taken into account when calculating depreciation. It can, however, be claimed as a separate interest expense (but that can be done regardless of the depreciation method and the method would not affect interest amounts).
Now, depreciation is based on the historical cost of the item in question, regardless of interest. Therefore, regardless of the depreciation method, the total amount of depreciation will be the same. If you are getting different amounts of total depreciation I think you're calculating depreciation for one or both of the methods incorrectly. Based on your description, I'm guessing you're doing too much work for SL. If the original cost is $150, the depreciable base is $150-$10(salvage value) and then divided by 7 year life to determine annual depreciation. I'm not sure why you think you need to calculate an annuity.
Double declining can be a little trickier. The depreciable base is the original cost. Salvage value is not subtracted at the beginning. The depreciation rate will be double the SL so instead of 1/7 you'll multiple your depreciable base by 2/7. Now the tricky part is that the depreciable base changes for year to year using this method. The first year is the original cost. The second year, and every year thereafter, it is resulting amount from the following calculation (original cost - accumulated depreciation).
Hey, thanks for your reply, it was really helpful. Before I asked on here, I did some Googling and what I read more or less reflected what you've said and I think there's been a misinterpretation between me and my professor. I was thinking of imaging depreciation as a kind of positive cash flow in a discrete cash flow diagram and then comparing the values by more or less doing an NPV calculation at the end of the project life, so since SL would be seen as a constant cash flow, I saw it as an annuity. Since for DD, yearly depreciation isn't constant, I had to calculate the terms separately. From my understanding with what you've said though, this isn't a correct way to see depreciation, so it's not valid. I'll have to clarify this with my professor.
Thank you!
CPA (Canada) here - wondering if you could expand a bit when you say :
In Canada, accounting depreciation is not deductible for tax purposes. It's added back and the government prescribes a set rate for the type of asset, and this is the amount you deduct for tax. So basically your choice of depreciation has no effect on taxes, just on your accounting income.
Is the situation different in the US? That'd be mighty interesting if so.
You're right, of course. I was incorrect when I said taxes would be less since IRS requires the use of MACRS depreciation for tax purposes and there is often a difference between book depreciation and tax depreciation that has to be reconciled. My only defense is that it was late and rushed my reply.