Which Depreciation Method is the Best?

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Offline ummekulsum

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Which Depreciation Method is the Best?
« on: July 31, 2013, 06:02:39 PM »
Why do companies depreciate long-term assets?
It is important to remember that depreciation is an attempt to match expenses with revenues (matching concept).  Accountants try to spread the cost of the asset over the service life of the asset.  Do not make the mistake of thinking that depreciation is an attempt to value the asset.  Depreciation and market value have nothing in common.  There are other accounting techniques that are employed when an asset's market value and an asset's book value become very different.
 Why are there so many different methods of depreciation?
Not long ago (about 100 years) there were no accounting rules.  Accounting methods began to be developed during the industrial revolution.  Each company and industry made up their own way of doing accounting.  Sometimes an accounting method was developed because the accountants thought the method would best match revenues and expenses.  Other times accountants would make up a depreciation method because the method would help management reach an objective such as making the net income look better or worse than it otherwise would look.  Sometimes the government makes up depreciation methods in order to stimulate or dampen the economy and for other political reasons.  By tradition, many of these accounting methods are accepted and still in use today.
 Which method is the best?
Since the objective of depreciation is to match revenues and expenses, it is probably best to choose the method that meets that requirement.  Sometimes a machine will be more productive in the early years and less productive in the later years.  An accelerated method may be best in cases such as that.  Although matching revenues and expenses is important, accountants are expensive and the cost-benefit rule comes into play.  For that reason, many accountants will just use a straight-line method to keep things simple ("close enough").
 When doing the accounting for very small businesses, accountants will often use the exact same depreciation method that was reported on the business's tax return for the company's books.  Not an accepted accounting practice, but it does keep things easier for the accountant (saves time and money) and the business owners generally do not care.  Still, some accountants (sometimes directed by management) choose a depreciation method that will make net income and assets look better (e.g. to help stock prices or obtain a loan).  Research has shown that most investors and bankers recognize such ploys.  So..... which method is best?  The answer, as you may have guessed, depends on lots of factors.
 Can pick and choose different depreciation methods for for different assets within a company?
The answer is yes.  But here are a few things to think of first.  Tracking fixed assets in a large company ($100 million plus in revenue) can be frustrating for the accountants.  Even tracking assets in a small company can be a full-time job.  There are many reasons for this.  The biggest reason is that some people within a company are not very good about telling the accountants when a fixed asset is purchased, sold, or transferred to a different location.  This is true even when there are policies and procedures in place.  All of this makes accounting for fixed assets very confusing.  Just think of how confusing things would become if an accountant assigned a different depreciation method for each individual asset purchased. 
Usually, accountants will divide fixed assets into groups of similar assets based on function.  For example, all vehicles will be placed in a group and all computer-related equipment will be placed in another group, etc..  Any asset that is purchased is placed in the appropriate group and then depreciated in a similar fashion.  Each group can have its own depreciation method, but assets within that group are depreciated in a consistent manner.  This does not help when employees do not tell the accountant that an asset was purchased, sold or transferred, but at least it does keep things a little easier.