Methods of Depreciation

Quick Answer

Depreciation is the systematic allocation of a tangible long-lived asset's cost over its useful life. It reduces book value and reported earnings but is a non-cash expense. The two methods tested are straight-line (equal across years, used for GAAP) and accelerated (front-loaded, used for tax via MACRS). Natural resources are depleted, not depreciated; intangibles are amortized.

Closing the Function 3.1 analytical toolkit is depreciation: the second major accounting-policy choice on the Series 6 outline. Like the inventory method, depreciation reshapes both the balance sheet and the income statement, and like inventory, it is a non-cash expense that separates accounting earnings from cash flow.

What is the purpose of depreciation?

  • Depreciation: the systematic allocation of the cost of a tangible long-lived asset (property, plant, equipment) over its useful life
  • Depreciation reduces the book value of assets on the balance sheet and reduces reported earnings on the income statement
  • Depreciation is a non-cash expense: it reduces accounting earnings but does not reduce cash flow
  • Land is not depreciated (indefinite useful life); only tangible assets with a finite useful life are depreciated

Exam Tip: Gotchas

  • Depreciation is a non-cash expense. It reduces reported earnings but does not reduce cash. A company with large depreciation can report low earnings while generating strong cash flow. The cash flow statement adds depreciation back to net income in computing operating cash flow.
  • Land is not depreciated. Its useful life is indefinite. Only tangible assets with a finite useful life (buildings, machinery, vehicles, equipment) are depreciated.

What are the two main methods of depreciation?

The Series 6 outline names "methods of depreciation" generally. The two families the exam tests are straight-line and accelerated.

MethodDescriptionPatternTypical Use
Straight-line depreciationEqual depreciation expense each year of the asset's useful lifeFlat across yearsGAAP financial reporting; produces steady, comparable earnings
Accelerated depreciationLarger depreciation expense in early years, smaller expense laterDeclines over timeTax reporting (Modified Accelerated Cost Recovery System (MACRS)); better matches economic wear on many assets; larger early-year tax deductions

Straight-line formula:

Annual depreciation expense=Cost−Salvage valueUseful life\text{Annual depreciation expense} = \frac{\text{Cost} - \text{Salvage value}}{\text{Useful life}}
  • Accelerated methods (MACRS, double-declining balance, sum-of-the-years'-digits) shift depreciation toward the early years
  • Many companies use straight-line for book (GAAP) purposes and accelerated (MACRS) for tax purposes
  • The resulting timing difference creates a deferred tax liability on the balance sheet
  • MACRS is the IRS depreciation system; it is not GAAP-compliant and is used only for tax calculations

Exam Tip: Gotchas

  • Straight-line spreads depreciation equally across years. Accelerated front-loads depreciation into early years.
  • Companies often use straight-line for GAAP books and accelerated (MACRS) for tax. The resulting timing difference creates a deferred tax liability.
  • The Series 6 exam tests the concept, not the specific MACRS tables. Know the direction of the effect and the book vs. tax distinction.

How does depreciation affect earnings quality?

  • Two companies with the same asset base may report very different earnings depending on the depreciation method chosen
  • The depreciation method and useful-life assumption are disclosed in the accounting-policies footnote
  • A change in depreciation method (e.g., straight-line to accelerated) is a change in estimate that must be disclosed and explained

Think of it this way: Depreciation is an accounting estimate, not a cash outflow. The cash left the company when the asset was purchased. The depreciation expense just spreads that historical cash outlay across future periods. Two companies can spread the same original outlay across different schedules and report very different earnings in any given year.

What is depletion and how does it differ from depreciation?

  • Depletion is the analog of depreciation for natural resources (oil, gas, timber, minerals)
  • Depletion reduces the book value of the natural-resource asset as it is extracted
  • Like depreciation, depletion is a non-cash expense
  • Natural resources are depleted (not depreciated); buildings, machinery, and equipment are depreciated

Exam Tip: Gotchas

  • Tangible assets with a finite useful life are depreciated. Natural resources are depleted. Intangibles (patents, copyrights, licenses) with a finite life are amortized. The three terms are not interchangeable.
  • Depletion is a non-cash expense just like depreciation. It reduces the book value of the natural-resource asset on the balance sheet and reduces reported earnings on the income statement, without moving cash.