How to choose between straight-line depreciation and accelerated depreciation methods

How to choose between straight-line depreciation and accelerated depreciation methods?

Long-term assets, also known as non-current assets, are used to produce goods or to supply services, rentals, or administrative purposes. They can be tangible or intangible and are expected to benefit the company for over one year. The most common long-term assets for SMEs are:

  • Property, Plant, and Equipment (In short: PPE): land, buildings, machinery, fixtures, and vehicles
  • Intangible assets: trademarks, patents, licenses, customer lists, franchises, etc.

This article explains how long-term tangible assets can be depreciated and intangible assets are amortized. The straight-line depreciation and accelerated depreciation method are covered as well as the unit-of-production method.

1. Long-term tangible assets are depreciated and intangible assets are amortized

Both PPE and intangibles can represent significant value because these assets benefit a company for over one year. Tangible assets are assets with physical substance while intangible assets are non-monetary assets that lack physical substance.

What both PPE and intangibles have in common is that they represent costs that the company has already incurred. These costs were capitalized and recognized as an asset instead of having them immediately expensed through the income statement. For example, if a company purchases long-term assets such as utility vehicles for a purchase price of $1 million, it can reasonably be expected that these vehicles will generate benefits for the company over several years. This period is what we call the useful life of the vehicles. You can also think of it as the life expectancy of the vehicles.

By recording the vehicles as an asset of $1 million instead of recording a $1 million expense, the company’s profit is not affected by the total invoice in the year of purchase. Instead, the purchase price is systematically and rationally spread over time. If the entire expense had been recorded in one-time, the company’s operating profit would have been $1 million lower. By capitalizing the vehicles, the purchase price is expensed over multiple periods. This results in an increased profit in the year of purchase. On the flip side, it lowers the profitability in future periods.

1.1. Fixed assets

A company recognizes fixed assets at their historical cost in the balance sheet. The distribution of the historical cost of PPE over its useful life is called depreciation. Every year the company will record a portion of the historical cost as a depreciation charge in the income statement. By consequence, the carrying value of the asset, also known as the book value, is reduced each year by the depreciation charge until the asset is fully depreciated. The carrying value is equal to the historical cost minus the total depreciation.

Land is also a tangible asset, but it is not depreciated because it is considered to have an infinite useful life.

1.2. Intangibles

Intangible assets are identifiable, non-monetary assets without physical presence. They are essentially intellectual property rights such as trademarks, licenses, or patents.

The cost of intangible assets, just like tangible assets, is also distributed over their useful life. This is also known as amortization.

Goodwill is a notable exception. It arises because of a business combination. It represents the excess purchase price that was paid to purchase another company. It has an indefinite useful life, and it cannot be amortized. Instead, it is annually tested for impairment.

1.3. Summary table

The following table provides you with a quick overview and some common terminology.

Asset depreciation and amortization summary table

2. Fixed assets depreciation methods

Several depreciation methods exist to spread the fixed assets’ expenses over their useful life. A company should choose the depreciation method that best reflects when the company will enjoy the economic benefits associated with the asset.

They fall into three broad categories:

  • Straight-line depreciation method
  • Accelerated depreciation method
  • Units-of-production method

Assume that company X bought a machine for $15,000 with an expected residual value of $1,000 and an estimated useful life of 5 years. The company depreciates the asset based on the straight-line method. Before we can calculate the depreciation expense, we need to determine the depreciable base. It can be found by simply subtracting the salvage value, also called the residual value, from the historical cost.

2.1. How to calculate the historical cost?

The historical cost includes all the expenses incurred to prepare the asset for its intended use. It comprises:

  • The purchase price after deducting trade discounts and rebates, but including import duties and non-refundable purchase taxes.
  • Any costs that are directly attributable to deliver the asset to the location and condition necessary for management’s intended use (such as delivery, installation, and assembly fees).
  • Borrowing costs attributable to the PPE. Under IFRS, the capitalized interest expenses are reduced by temporary investment income earned from these borrowings.

2.2. Straight-line depreciation method

With the Straight-line method of depreciation, the company will record the same amount of depreciation for each year of the asset’s useful life. That’s why it is by far the simplest method.

Recall that the initial value of the asset was $15,000. Every year, the carrying value is reduced by $2,800 because of the annual depreciation expense. After 5 years, the total annual depreciation and accumulated depreciation are both $14,000. The asset has been fully depreciated and its remaining value is equal to the salvage value of $1,000.

2.3. Accelerated depreciation method

Accelerated depreciation methods result in lower depreciation charges over the useful life of the asset. The two most common accelerated methods are declining-balance and sum-of-the-years’-digits.

Accelerated depreciation methods are common for tax purposes to reduce the total tax bill.

2.3.1. Declining-balance method

The declining-balance method, unlike other methods, will not use the depreciable cost to compute the annual depreciation expense, but it will use the book value of the asset. By multiplying the book value at the beginning of the year by the declining balance depreciation rate, the carrying value of the asset reduces much faster compared to the straight-line method.

The total depreciation expenses under both methods are the same. Under the reduced-balance method, the depreciation charges are recognized faster. They are front-loaded while under a straight-line method they are equally divided in time. The declining balance percentage remains constant throughout the useful life of the asset.

To illustrate this, we will revisit our previous example. Instead of applying a depreciation rate of 20% (100%/5 years), which is equal to the straight-line method, we will apply a depreciation rate of 40%. This is also called the double-declining-balance.

*NOTE: The annual depreciation expense in year 5 will be adjusted from 778 to 944 for book value to be equal to the residual value.

2.3.2. Sum-of-the-Years’-Digits (SYD)

This method is another accelerated depreciation method. Under this method, the depreciable base of $14,000 is depreciated by an SYD faction. Just like previously, the useful life is 5 years, so the SYD faction would be computed as follows: 1 + 2 + 3 + 4 + 5 = 15. This is the denominator. The SYD faction to calculate the first-year depreciation is equal to 5/15, the second year is 4/15, the third year is 3/15, etc.

2.4 Units-of-production method

Under the unit-of-production method, the depreciation expense varies based on the actual output from the asset over its useful life. This depreciation method is not based on time but the actual production. It makes it an excellent choice for a factory, machinery, and equipment.

Let’s use our previous example and create a depreciation schedule using the unit-of-production method for this asset. The purchased machine can produce 100,000 units. The actual units produced are 10,000 in year 1, 20,000 in year 2, 30,000 in year 3 and 4, and 10,000 in year 5.

3. Amortization of intangible assets with finite useful lives

Intangible assets are not depreciated but amortized over their useful lives. Amortization schedules are usually easier because the asset is amortized on a straight-line basis and there is also no salvage value. Each year the amortization expenses reduce the book value of the intangible asset by the amortization expense until the intangible asset is fully amortized.

For example, if a license is acquired for $50,000 with 5 years of useful life, the annual amortization expense is $10,000. This implies the balance sheet amount will reduce by $10,000 annually over the next five years.

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