Question

Prepare a research paper on the various methods of depreciation. Your research should include:

1. An analysis of why depreciation is an allocation process and not valuation process.
2. A description of the following depreciation methods:
   1. ACRS
   2. MACRS
   3. traight-line depreciation.
3. An explanation of the how cost recovery is different for natural resources.
4. An explanation of why there could be a difference between the depreciation amount on a company’s book (book depreciation) and the depreciation amount on a company’s tax return (tax depreciation).

Answer 1

The Statement that ‘depreciation is a process of allocation not of valuation’ is found in the following definition of AICPA (US):

“Depreciation accounting is a system of accounting which aims to distribute the cost of tangible capital assets, less salvage (if any) over the estimated useful life of the unit in a systematic and rational manner. It is a process of allocation, not of valuation”.

This definition represents depreciation as an allocation of cost and is based on the following assumptions

(i) Depreciation is that part of the cost of a fixed asset which is not recoverable when the asset is finally put of use.

(ii) Depreciation is related to the expected benefits derived from the asset and it is possible to measure the benefits.

(iii) Depreciation accounting is not an attempt to measure the value of an asset at any point of time. But there is only an attempt to measure the value of the benefit the asset has provided during a given accounting period and that benefit is valued as portion of the cost of asset.

(iv) Depreciation accounting does not itself provide funds for the replacement of a depreciable asset, but the charging of depreciation ensures the maintenance, in fact, of the original money capital of the entity.

Description of following depreciation methods.

1.) ACRS.

  

The Accelerated Cost Recovery System (ACRS) is a depreciation method that assigns assets periods of cost recovery based on specific IRS criteria. Since 1986, the Modified Accelerated Cost Recovery System (MACRS) has been far more prevalent.

HOW IT WORKS (EXAMPLE):

Following the Economic Recovery Tax Act of 1981, the IRS implemented ACRS for assets purchased between 1980 and 1986. The ACRS shifted the focus of asset depreciation away from the customary straight-line approach, based on lifespan, to an approach based on the cost to a company of an income-generating asset across fixed periods of 3, 5, 10, and 15 years .

In this way, ACRS was intended to increase the amount of periodic depreciation associated with a given asset by dividing the asset's cost into fewer periods, thus accelerating the process of depreciation. Higher periodic depreciation amounts were, consequently, reportable for each period.

To illustrate, suppose company XYZ purchased an asset at a cost of $5m. Under straight-line depreciation, this asset depreciated completely over the course of 20 years (a reportable rate of $250k per year). If this asset qualified under ACRS for depreciation over 10 years, the rate of depreciation would increase to $500k.

2.) MACRS

(MACRS) is the current tax depreciation system in the United States. Under this system, the capitalized cost (basis) of tangible property is recovered over a specified life by annual deductions for depreciation. The lives are specified broadly in the Internal Revenue Code. The Internal Revenue Service (IRS) publishes detailed tables of lives by classes of assets. The deduction for depreciation is computed under one of two methods (declining balance switching to straight line or straight line) at the election of the taxpayer, with limitations.

3.) Straight line Method

Straight line depreciation method charges cost evenly throughout the useful life of a fixed asset.

This depreciation method is appropriate where economic benefits from an asset are expected to be realized evenly over its useful life.

Straight line method is also convenient to use where no reliable estimate can be made regarding the pattern of economic benefits expected to be derived over an asset's useful life.

Formula

Straight line depreciation can be calculated using any of the following formulas:

● Depreciation per annum	=	( Cost   −   Residual Value )
		Useful Life

● Depreciation per annum

=

( Cost − Residual Value ) x Rate of depreciation

Difference between cost recovery method and depreciation.

Cost recovery refers to the deduction of a portion of the cost of an asset, used in a business or for the production of income, over its useful life through depreciation, amortization, or depletion. The recovery of the cost of tangible property is through depreciation, whereas the recovery of the cost of intangible property, such as goodwill or patents, is through amortization, and the cost of natural resources is recovered through depletion. These deductions are allowed because of the recovery of capital doctrine, which holds that the return of the invested capital is not taxable.

Cost recovery methods only apply to assets that:

• are subject to exhaustion, wear and tear, or obsolescence;
• are used in a trade or business or other income-producing activity — personal property is not depreciable; and
• have a useful life greater than 1 year.

The cost of assets with an indeterminable life, such as antiques or undeveloped land can only be recovered by selling the property.

Reasons for difference between depreciation amount in books and tax returns.

The books depreciation expense is the amount recorded on the "books" and reported on the financial statements. This depreciation is based on the matching principle of accounting.

For example, if a machine costs $500,000 and is expected to be used for 10 years and to have no salvage value at the end of the 10 years, the annual depreciation expense might be $50,000 each year. (This assumes the straight-line method and that the machine was acquired on the first day of an accounting year.)

On the Other hand "tax depreciation" is recorded on the company's income tax returns and will be based on the Internal Revenue Service's rules.

The IRS might specify that the machine is a 7-year machine regardless of a company's situation. The IRS rules also allow a company to accelerate the depreciation expense. Accelerated depreciation means taking more depreciation in the first few years and less depreciation in the later years of the machine's life.

This saves income tax payments in the first few years of the asset's life but will result in more taxes in the later years. Companies that are profitable will find the accelerated depreciation to be attractive.

Therefore , there is a difference between the depreciation amount in "company's books and tax returns.