Methods to Demonstrate Depreciation

Depreciation is simply the systematic allocation of cost of a capital expenditure item over its useful life. In reality, depreciation is nothing more than an accounting charge that reduces the overall value of an asset, due to its depletion, for income tax purposes. Depreciation can be calculated with many methods. To demonstrate depreciation we shall present both the straight-line and the modified accelerated cost recovery system (MACRS) methods. MACRS is the most common for tax depreciation because, as the name implies, they allow for accelerated depreciation.

Straight-line depreciation is simply

where:

Dn = depreciation allowance in year n

I = cost base

S = salvage value

n = useful life of asset in years

Note that the cost base includes both the actual cost and the cost to put the asset into operation. The book value of the asset at year n can be expressed as

MACRS is used both for tax purposes and for internal accounting. It allows for the recovery of more costs early in the life of the investment. Depending on the type of asset, the Internal Revenue Service (IRS) allows for different cost recovery periods. A yearly depreciation rate is then multiplied by the cost base to determine the annual depreciation amount. Example 3.1 shows how the MACRS allows for earlier depreciation of assets when compared to the straight-line method. With the exception of this example, the details of MACRS depreciations are not presented because those rates are subject to change by the IRS.

EXAMPLE 1

Your small consulting company is evaluating a circuit board testing machine. The device costs $35,000 and the maker estimates that it will have a salvage value of $6000 after 5 years of use. Determine the annual depreciation using both the straight-line method and the MACRS method.

SOLUTION

a. Straight-line:

b. MACRS: Under IRS guidelines (IRS, 2009), a circuit board testing machine would be classed as “high-technology equipment,” which as a 5-year recovery period. Thus, the equipment could be depreciated according to this schedule:

Note that a 5-year recovery period is depreciated over 6 years. This is based on the assumption that the equipment will be sold during the sixth year. Also note that if a piece of capital equipment is sold before it can be depreciated fully, one-half the normal amount can be depreciated during that year.

Internally developed software is amortized on a straight-line basis over 5 years (or shorter if you can show it is appropriate). Software obtained as part of a business acquisition can be amortized over 15 years. Purchased software is generally amortizable over 3 years. Depreciation can play a role in choosing whether to develop in house or procure commercially, because software can be amortized over different time horizons depending on whether it is an off-the-shelf item or is internally developed.