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Selection of Depreciation Method in Financial Accounting
Several factors influence managers’selection of a depreciation method for financial reporting. Managers might wish to provide financial statement readers with useful information. This would prompt them to select a depreciation method that best reflects the pattern of benefit usage. For example, if an asset is uniformly productive throughout its life, the straight-line method would be chosen.
Additionally, however, some economic issues may influence their decisions. If managers’ compensation is tied to reported accounting earnings, managers are likely to prefer the straight-line method because it initially results in lower depreciation charges and higher reported income. Lending agreements may also play a role. For example, some agreements require the firm to keep its debt to assets ratio below a specified value. This ratio contains total assets in the denominator. Because recorded asset values decline more quickly under accelerated depreciation methods, managers can reduce the likelihood of violating such agreements by selecting the straight-line method.
Firms do not generally use the same depreciation method for both financial reporting and tax purposes. MACRS is required for tax purposes but is not always acceptable for financial reporting. This is partially due to the permissive nature of MACRS. For example, under MACRS, cars are given a five-year life and a zero residual value. These may not be realistic assumptions for many firms and might yield misleading financial statements. Also, as mentioned earlier, firms frequently wish to report the lower depreciation expense associated with the straight-line method on their financial statements. In fact, as figure 6.2 shows, the vast majority of publicly held companies uses the straight-line method for financial reporting.
Figure 6.2 - Selection of Depreciation Methods
Depreciation Methods and Topics
- Straight-Line Method (Depreciation Methods)
- Sum-of-the-Years’-Digits Method (Depreciation Methods)
- Declining-Balance (DB) Methods (Depreciation Methods)
- Tax Depreciation
- Selection of Depreciation Method
- Misconceptions About Depreciation
Property, Plant, and Equipment (PPE) Topics
- Property, Plant and Equipment (PPE)
- Initial Valuation of Property, plant, and equipment (PPE)
- Depreciation of Property, plant, and equipment (PPE)
- Expenditures After Acquisition - Property, plant, and equipment (PPE)
- Disposals of Property, plant, and equipment (PPE)
- Write-Downs - Property, plant, and equipment (PPE)
- Financial Statement Presentation of Property, plant, and equipment (PPE)
- Utilization of Property, plant, and equipment (PPE)
- Percentage of PPE Depreciated (Age)
- Evaluation of the Accounting for Property, Plant, and Equipment (PPE)
Related Noncurrent Assets Topics
