There are a couple of different depreciation methods that are commonly used—one for financial accounting purposes, and one for tax purposes.
- In accounting, depreciation is allocating the cost of an item, an asset, over the time period that is benefited by that asset. For example, a company purchases a piece of machinery with which to produce products that can be sold, thereby generating revenues. Part of the cost of the revenue being generated, because of that machine, is the cost of that machine. Somehow, the cost of that machine must be allocated and matched to the revenue that it's generating. That is what depreciation is in an accounting context.
The systematic allocation of an asset's cost over its estimated useful life. The objective of depreciation is not to estimate an asset's decline in value. It's objective is to match costs with revenues. How to do that? Match costs with revenues? Well to do that matching, companies use what are called depreciation methods. There are two that gets the most attention: Straight line and MACRS. The Straight line method of depreciation results in the same amount being depreciated each and every year.
In other words, if you were to plot the amount of depreciation each year on a graph, the result would be a straight line. Well that makes sense. Companies estimate a useful life for an asset. They estimate a value at the end of the expected life of the asset and they spread the difference between cost and the estimated salvage value over that estimated useful life. Big companies use the Straight line method because big companies, with big accounting staffs, keep multiple sets of books. One set of books is used to produce financial statements that are given to investors and creditors.
Now, here's the thing, big companies also use MACRS. But what is MACRS? MACRS stands for Modified Accelerated Cost Recovery System. MACRS is the tax depreciation system used by companies in the United States. Under the tax rules in the United States, the cost of tangible property, machines, cars, computers, the cost used in a business can be deducted to arrive at taxable income. But the government is very specific about how those costs of tangible property are to be deducted.
In fact, the government will tell a taxpayer based on the type of tangible property, how much is to be deducted each year and the time period over which that deduction will occur. There's no estimating here. Big companies, the ones producing financial statements for use by investors and creditors, also need to file tax returns. They also have a set of books for tax purposes. Two sets of books for two different reasons. Small companies, those who are not so much concerned about providing financial information to investors and creditors, tend to keep just one set of books.
They accumulate financial information for tax purposes and they also use that information to help them make business decisions. Small companies tend to keep just one set of books for tax purposes and they use MACRS when they depreciate. Big companies, those with an accounting staff, have two sets of books and actually sometimes they have more than that. And they use MACRS and Straight line when allocating the cost of assets over time. MACRS for tax purposes and Straight line for financial accounting purposes.
Different depreciation methods for different purposes. The two most common methods you'll hear about are Straight line and MACRS. There are others, but those are the two most common.
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