On what type of business should the following depreciation methods be more appropriate?

Straight-line method

Declining balance (or reducing balance method) and sum-of-the-years'-digits method

Unit-of-production

And please include your sources. I just need a little help with the research topic my teacher assigned me to. If you can, please include the source.

I've searched for their definitions and concepts. And I can draft out in the businesses in my mind, but I'm just unsure. Their definitions are quite... vague.

Thank you so much.

1 Answer

Relevance
  • 9 years ago
    Favorite Answer

    Actually, those methods have less to do with the type of business and more to do with the asset itself.

    Assets are depreciated as a way of recognizing that using the asset lessens the value that the asset is worth. A 20 year old building is not worth the same as a brand new building, even if they were built exactly the same. The same goes for other assets like trucks and production equipment.

    Straight-line method is best used for buildings and intangible assets such as patents and copyrights. This is because buildings wear-out steadily rather than rapidly, and it's impossible to use the "Unit-of-production" method on a building, patent or copyright. Straight-line could be used for other things too, like cars or equipment if management feels that it is appropriate. Such a determination conforms with GAAP, but the IRS sets its own rules on depreciation depending on what type of asset it is. Intangible assets must use straight-line according to the IRS; however buildings do not use straight-line under the tax code.

    Declining Balance or Double Declining Balance is often used on assets that depreciate more value in the first few years than the last few years. Computers are a great example of this and I would recommend that they be depreciated using Double-Declining Balance. Much of the IRS tax-code uses the Declining Balance method, called MACRS. You may elect to not use MACRS if you can use a method not based on years, such as Unit of Production.

    Unit of Production is good for factory equipment that has a useful life of so many parts... if a machine is rated to be junk after 1 million parts are produced, then unit of production is a great way to depreciate it. It can also be used to depreciate vehicles, the units are miles.

    When only considering GAAP, not tax code, you have much leeway in which method you use for each asset. You may ultimately decide on one method over another, purely for business reasons... so long as you stay consistent with that method, it is generally acceptable under GAAP. This means you can pick methods that suit your business. If you want to report higher depreciation expense in the first couple years, then you can use Double Declining Balance. If you want a consistent level of depreciation each year, then you can use Straight-Line. This means that the type of business you operate does somewhat affect the type of depreciation you might use under GAAP.

    However... since whatever method you use under GAAP doesn't affect how you depreciate it under tax-code, whatever you choose is just window dressing for the financial statements issued to investors. Ultimately, GAAP's leeway in which depreciation method you use, allows a company to tweak their financial reports one way or another over a long period of time.

    Generally speaking, I would say Industrial businesses that manufacture products really aught to use unit of production. This way their depreciation expenses will increase in years where they are making more money, and decrease in years they are making less.

Still have questions? Get your answers by asking now.