Welcome back. Now that we know about what depreciation is, let's see how we can calculate it using a few different techniques. In this lesson, we'll start with two methods that have been around for a while. The straight line or SL approach, and the declining balance or DB approach. The first one should look familiar, so we'll begin there. In fact, there are three different techniques. The straight line and declining balance methods were how accounting departments across the United States determined depreciation prior to 1981. Congress made some changes in the Tax Code in 1986, and that led to how things are done today. The MACRS method, which stands for the Modified Accelerated Cost Recovery System. We'll look at MACRS next time. For now though, let's focus on the straight line and declining balance methods. MACRS is just a combination of these two. If we understand SL and DB, the MACRS is straightforward. With the straight line method, depreciation is uniform over the recovery period. Whereas, with the declining balance approach, depreciation is a percent of the book value over the recovery period. Let's start with the straight line method and see how that works. As we mentioned, the straight line depreciation method reduces the asset's book value uniformly over the entire recovery period. That means the depreciation expense is the same each year, determined by the difference between the cost basis and the salvage value, all divided by the number of years in the recovery period. The asset value or formerly the book value decreases each year by the amount of the annual depreciation expense, so the book value at the end of the year is just the book value at the end of the previous year less the current year's depreciation expense. The initial book value is just the cost basis, and the ending book value is just the salvage value or zero, if there is no salvage value. As you can see, this is exactly how we've been describing depreciation so far. We just didn't explicitly call it the straight line method. Here's a new example to show how it works. A company purchases an asset for $80,000. It has a five-year recovery period and is estimated to have a salvage value of $10,000. What's the annual depreciation expense and book value over time? I've set up a spreadsheet to show you how to determine the depreciation and book value. As usual, the data block is up top, and the input variables are in blue. The cost basis is $80,000, the recovery period is five years, and the salvage value is $10,000. The table illustrates how it all comes together. The first column just shows the recovery period going from time equals zero through five years. The second column is the annual depreciation expense, which is determined by the cost basis minus the salvage value divided by the recovery period. You can see, it's the same each year at $14,000. The third column is the book value, which starts at time equals zero at $80,000. The cost basis then decreases each year by the annual depreciation expense $14,000. After five years, you can see the book value is the salvage value of $10,000. The plot on the right is the book value over time, and shows why it's called the straight line approach because the book value decreases uniformly along a straight line. You should have a good understanding of the straight line approach by now. So let's move on to the declining balance method. The declining balance method reduces the asset's book value by a constant rate over the recovery period. That means the depreciation expense depends on the book value. It's determined in one of two ways. The declining balance or DB method is where the rate is 150 percent divided by the number of years in the recovery period. The double declining balance method or DDB is where the rate is 200 percent divided by the number of years in the recovery period. That makes the depreciation expense a fixed percentage of the previous year's book value seems a lot more complicated, I know. We better see an example of how this really works. Consider the case of a double declining balance approach to depreciating the same piece of equipment we had before. The one with an initial cost of $80,000, its cost basis, a salvage value of $10,000, and a five-year recovery period. The depreciation rate is determined from the 200 percent divided by the 5 years and the recovery period for a value of 40 percent or 0.4 in decimal form. Now watch what happens. The annual depreciation expense is just the previous year's book value multiplied by the depreciation rate, 0.4. For Year 1, the depreciation expense is $80,000 multiplied by 0.4 or $32,000. The book value at the end of Year 1 is now $80,000 less than $32,000 in depreciation or $48,000. In Year 2, the depreciation expense is $19,200 which is obtained from the previous year's book value of $48,000 multiplied times 0.4 again, and the new book value at the end of Year 2 is $28,800. That goes on for a few more years until we get to Year 5. If you use the formula for the depreciation expense here, you get $4,147. That would make the book value at the end of Year 5 less than the $10,000 salvage value and the IRS does not allow that to happen, so the final year's depreciation is whatever it takes to get to the salvage value. In this case, $368. Let's see how this looks on a spreadsheet. There's the spreadsheet on the left with a plot of book value versus time on the right. You can see I added a few lines to account for the declining balance rate of 200 percent and the depreciation rate of 0.4 which is calculated from cell B7 divided by cell B4. The plot is an interesting one as it decreases rather quickly at first, then starts to level off at the end of the recovery period. Why did the IRS make this approach more complicated than the straight line method? For one, the annual depreciation expense is higher earlier in the recovery period, and that better aligns with reality. Assets typically lose value faster early in their life. That also means that tax deduction is higher in the early years of the recovery period compared to the straight line method. In other words, depreciation is accelerated relative to the straight line method. However, there are two things to note with the declining balance approach. As we've seen the book value can never go below the salvage value because the IRS doesn't allow for that, and fortunately our colleagues in the Accounting Department keep track of all these things. The second though is more of a procedural problem. Because we're multiplying the book value by a rate, the declining balance method never can get to zero. If there's no salvage value the declining balance method by itself is a problem, but once again, our accounting colleagues have a fix for this issue. Before we get to the fixed though, compare the depreciation for the straight line method and the declining balance method. You can see much more clearly now that the declining balance accelerates the depreciation early on which reduces the book value much more quickly than the straight line method. The company benefits by getting a larger tax deduction in the early years of the recovery period and the IRS is okay with this. Let's get back to the fix now. The problem of never getting to zero is important because companies want to get the full tax benefit of depreciation and they don't using the declining balance approach. The fixed though is not as easy as you would think. You might consider that the accountants would get to the next to the last year and the recovery period, then just take the remaining book value as that year's depreciation expense like what we did when we had a $10,000 salvage value in our last example but no. It has to be more complicated than that, so let's take this one step at a time. The accountants figured out they can switch from the declining balance method to the straight line method at some point during the depreciation process, and when they do it forces the book value to be zero at the end of the recovery period. The annual depreciation using the declining balance method is compared to what it would be using the straight-line method, and you take whichever number is higher. It definitely starts off higher with the DB method, and at some point, the SL depreciation expense will be higher, and that's when the switch happens. The only complication here is the straight-line depreciation expense is calculated a bit differently from before. It's determined on a year-by-year basis, taking the book value at the end of the previous year and dividing that by the number of years remaining in the recovery period. Are you getting a headache yet? I am. Let's look at an example. Consider our $80,000 piece of equipment once again. Although this time there is no salvage value. Its value at the end of five years is zero. How can we get there? The spreadsheet has the depreciation calculated using the DB approach as before. Then, there was the depreciation expense using our modified SL approach, which is determined from the book value at the end of the previous year divided by the number of years remaining in the recovery period. For example, take year 3, the depreciation expense using straight line is $9,600, and that comes from the previous year's book value of $28,800 divided by the three years left and the recovery period: year 3, year 4, and year 5. If you follow that, now, let's see how the switching process works. At time equals 0, the book value is the cost basis once again, $80,000. At the end of year one, the depreciation from the declining balance method, $32,000 is clearly larger than that from the straight-line method, so we take the declining balance method. The book value at the end of year 1 is $48,000. At the end of year 2, the same thing happens. Depreciation using the declining balance method is $19,200, whereas it's only $12,000 for the straight-line method. We take the declining balance depreciation, once again, reducing the book value to $28,800. The same thing happens in year 3. But look what happens at year 4. The depreciation determined by the SL method is now larger than that from the declining balance approach. We take the SL depreciation of $8,640, and that reduces the book value to the same amount, $8,640. We have switched to the SL method for the rest of the recovery period. The final year in the recovery period, year 5, the straight-line depreciation is $8,640 once again, and that takes the book value to zero. You can see what happens on the plot of book value versus time. Perhaps all this is a little wonky, but maybe we should look at it as an elegant solution to a tricky financial problem. One more thing about depreciation methods, as we'll see in the next lesson, there was a significant change in the United States tax code back in 2018. Congress created something called bonus depreciation, which basically allowed companies to write off or expense the entire cost of the asset the year it was purchased. It didn't matter whether the equipment was $100 or $100,000, companies could expense the full amount the year it was purchased. As expenses like this are tax-deductible, the ability to expense the entire cost of the asset was like giving companies a huge tax deduction. Why would the government wants to do this? Basically to encourage companies to buy large capital items like equipment, for example, thus boosting the economy. Of course, such tax changes have a limited life and bonus depreciation is set to expire in 2022 unless Congress re-approves it, we'll have to see what happens. That's how the straight line and the declining balance methods work. Next up is MACRS, the Modified Accelerated Cost Recovery System. This turns out to be a combination of the straight line and the declining balance approaches. But the IRS has made it even easier to figure out. Let's take a short break and we'll come back to see how much easier the process is. I'll see you next time.
