Question

Your company has purchased equipment worth $40,000 and would like to compare the impact of straight-line depreciation versus accelerated depreciation (double declining method). The equipment has a five-year life and a salvage value of $0. (i) Compute the depreciation expense over the next three years for both the straight line and the accelerated method (you may earn partial marks if you show how you arrived at your answers) (ii) How a company would use one method over the other in order to better manage cash flows ?

Answer 1

i)

We are given,

Price of equipment = $40,000

No of yr of life = 5

Salvage value = 0

In straight-line depreciation, the value of the asset reduces uniformly over each period until it reaches its salvage value. Depreciation expense is the same for every yr.

Annual depreciation expenses = (Cost - Salvage value) / Useful life of asset

Annual depreciation expenses = (40,000 - 0) / 5

Annual depreciation expenses = $8,000

Hence depreciation expense using the straight-line method for yr 1, 2, and 3 is $8,000.

Using accelerated depreciation (double declining method),

An accelerated depreciation method counts expense more rapidly( twice as fast as the traditional method). The DDB method records larger depreciation expenses during the earlier years of an asset’s life, and smaller ones in later years.

Depreciation = 2 × Straight-line depreciation percent × Book value at the beginning

straight-line / annual depreciation rate = 100% / 5 = 20%

Yr 1 = 2 * 20% * 40,000 = $16,000

Yr 2 = 2 * 20% * 24,000 = $9,600

Yr 3 = 2 * 20% * 14,400 = $5,760

ii)

The most common reason for using accelerated depreciation is to lower our taxable income. It is better to take income tax savings earlier n the life of an asset.

Straight-line dep. is easier to calculate and looks better. Most companies use straight-line depreciation for financial statements and accelerated depreciation for income tax returns.

If you have any doubts please let me know in the comments. Please give a positive rating if the answer is helpful to you. Thanks.