Accounting Financial and Tax Depreciation Methods
It is a common misnomer that and organization needs to use the same method of accounting depreciation for financial reporting and tax purposes. An organization must decide if it is cost effective to use more than one depreciation method and furthermore which method or combination of methods to use. Each method carries with it a distinct list of benefits and draw backs and can be customized to fit a company’s unique situation.
There are three main types of depreciation techniques.
Straight-Line – Simplest deprecation technique. A company estimates the salvage value of the item and the usable life. It then subtracts the scrap value from the original cost and divides by the life span in years to get the annual depreciation expense. The largest benefit of this method is that it is very simple to understand and easy to use. A major drawback to this technique is that it does not acquire all the possible tax benefit early in the life cycle, effectively leaving those tax dollars on the table longer.
Double-Declining Balance – This technique factors in the fact that an item is more useful near the time of purchase as opposed to near the end of its life. The organization records a larger expense of depreciation in the first few years and it continues to decline until the scrap value is reached. A major benefit to this method being largely front loaded; where most of the depreciation is taken at the beginning of the life cycle is in reducing the taxable income quickly. This method is more complicated and requires involvement of the technical staff to accurately estimate an items life expectancy.
MACRS – The method approved by the IRS. Similar to the Double-Declining balance method it allows for most of the depreciation expense to be absorbed near the beginning of an items life to maximize the tax benefit of the additional expense. This allows a company to retain more income early in the depreciation cycle while reducing their overall tax exposure. This carries the same benefits and drawbacks as the double declining balance method.
On the surface some organizations will identify the benefits of using one depreciation method for financial accounting and a different method for tax accounting. Mainly it allows the company to reduce their taxable income now while still maintaining an easy to read balance sheet. The costs associated with the extra staffing and complexity of tax law may make this type of approach cost ineffective for smaller organizations, but for larger corporations that have the purchase a large quantity of equipment on a yearly basis a dual method accounting system may be cost effective.
The smaller organizations that cannot carry the additional burden of increased staff necessary to keep up with ever changing tax law, the simpler approach of maintaining a single method of recording depreciation. In addition to saving on staffing costs, the tax benefit realized with a two method approach in a smaller organization is minimal at best. Like most other financial and tax reporting functions each company must find the method and situation that is both cost effective and maintainable.