Financial Accounting: An Integrated Statements Approach, 2nd Edition

Chapter 9 Fixed Assets and Intangible Assets 409

the declining-balance method is called an accelerated depreciation method. This

method is most appropriate when the decline in an asset’s productivity or earning

power is greater in the early years of its use than in later years. Further, using this

method is often justified because repairs tend to increase with the age of an asset. The

reduced amounts of depreciation in later years are thus offset to some extent by in-

creased repair expenses.

Depreciation for Federal Income Tax

The Internal Revenue Code specifies the Modified Accelerated Cost Recovery System

(MACRS)for use by businesses in computing depreciation for tax purposes. MACRS

specifies eight classes of useful life and depreciation rates for each class. The two most

common classes, other than real estate, are the five-year class and the seven-year class.^3

The five-year class includes automobiles and light-duty trucks, and the seven-year

class includes most machinery and equipment. The depreciation deduction for these

two classes is similar to that computed using the declining-balance method in that

larger depreciation amounts are recorded in earlier periods.

In using the MACRS rates, residual value is ignored, and all fixed assets are as-

sumed to be put in and taken out of service in the middle of the year. For the five-year-

class assets, depreciation is spread over six years, as shown in the following MACRS

schedule of depreciation rates:

5-Year-Class

Year Depreciation Rates

1 20.0%

2 32.0

3 19.2

4 11.5

5 11.5

6 5.8

100.0%

To simplify its record keeping, a business will sometimes use the MACRS method

for both financial statement and tax purposes. This is acceptable if MACRS does not

result in significantly different amounts than would have been reported using one of

the three depreciation methods discussed earlier in this chapter.

Revising Depreciation Estimates

Revising the estimates of the residual value and the useful life is normal. When these

estimates are revised, they are used to determine the depreciation expense in future pe-

riods. They do not affect the amounts of depreciation expense recorded in earlier years.

To illustrate, assume that a fixed asset purchased for $140,000 was originally esti-

mated to have a useful life of five years and a residual value of $10,000. The asset has

been depreciated for two years by the straight-line method at a rate of $26,000 per year

[($140,000$10,000) ÷ 5 years]. At the end of two years, the asset’s book value (un-

depreciated cost) is $88,000, determined as follows:

Asset cost $140,000

Less accumulated depreciation ($26,000 per year 2 years) 52,000

Book value (undepreciated cost), end of second year $ 88,000

Q.What is the third-year
MACRS depreciation for
an automobile that cost
$26,000 and has a resid-
ual value of $6,500?

A.$4,992 ($26,000 
19.2%)

3 Real estate is in 27^1 – 2 -year and 31^1 – 2 -year classes and is depreciated by the straight-line method.