Another term used for depreciation is amortization, which means spreading an amount over time. This term describes the process of allocating the cost of an intangible asset from the balance sheet to the income statement as an expense. A lot of times you will see the term amortization appear when dealing with 401(k) accounts. Most, but not all, 401(k) plans allow investors to take out loans against their 401(k). These investors are taking money from their own account with the intention of paying themselves back. When this is done, a payment plan is formulated, and an amortization schedule is prepared so that a specific amount of money will be deducted from each paycheck and put back into the 401(k) over time. This amount of money is calculated using the length of how long the loan will be outstanding, or vice versa. With that said, the amount of money that is being repaid into the 401(k) account paired with the length of the loan itself constitutes the amortization schedule. This is how the loan terms are established.
Depreciation has three main methods which are based on time and/or how often the asset is used over a period of time. The three methods I will discuss are: straight-line, declining balance (accelerated), and sum-of-years’ digits (accelerated). Straight-line depreciation takes an equal amount of the cost of an asset and distributes or expenses it over a period of time. This is why when shown on a graph, there is a straight line example. It is calculated by dividing the amount to be depreciated by the number of periods over which the asset is being depreciated. A sub-category of straight-line depreciation is the units-of production method. This method is based on periodic use and life expressed in terms of asset utilization.
Another method of depreciation is accelerated, which is categorized as both declining balance and sum-of-the years’ digits, which describes the fact that the greatest amount of functional or economic obsolescence occurs in the early years of the long-lived asset’s use. In other words, more depreciation occurs in the earlier stages of an asset’s lifespan. The declining-balance method is calculated by multiplying the net book value of an asset by a constant rate. There is also double-declining balance, which just means that the depreciation rate obtained using the straight-line depreciation method is doubled. Under these accelerated methods, the difference between the economic/functional obsolescence between the first few years of an asset will be significantly higher than toward the end of the asset’s lifespan. Sum-of-the-years’ digits results in a faster rate of depreciation than straight-line, but a slower rate than double-declining.
Depreciation in accounting is used for two main purposes: to match its expenses with income and to make sure the values assigned to each asset are not over or understated. Many topics in accounting will tie in with each other at some point, and this is an example where the matching principle ties in with depreciation. Years ago, industries were trying to find ways to match the functional or economic obsolescence to the period in which it occurred in order to provide them with more meaningful and useful income statements for that time period. There were also systems that were set in place that were used by many firms to control depreciation for income tax purposes. The Modified Accelerated Cost Recovery System (MACRS) was established post-1986 as a means to “clean up” the already established ACRS. The main goal was to establish another method for calculating the depreciation deduction for these income tax purposes. The double-declining depreciation method is used under MACRS for determining the depreciation for most machines and equipment, and the straight-line method of depreciation is used for buildings.
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