How do the three depreciation methods compare, and when would a company choose each one?

Question

AcadiFi · Accepted Answer

Depreciation method choice is a management decision that directly affects reported earnings, asset values, and tax cash flows. Here is a practical comparison.

**The Three Methods:**

**1. Straight-Line (SL):**
$$	ext{Annual Depreciation} = \frac{	ext{Cost} - 	ext{Salvage Value}}{	ext{Useful Life}}$$

**2. Double-Declining Balance (DDB):**
$$	ext{Annual Depreciation} = \frac{2}{	ext{Useful Life}} 	imes 	ext{Beginning Book Value}$$
(Ignore salvage until book value reaches salvage)

**3. Units-of-Production (UOP):**
$$	ext{Annual Depreciation} = \frac{	ext{Cost} - 	ext{Salvage}}{	ext{Total Units}} 	imes 	ext{Units Produced}$$

**Worked Example: Redfield Manufacturing**

Redfield buys a stamping machine for $480,000, salvage value $30,000, useful life 5 years, total expected output 90,000 units.

| Year | Units | SL | DDB | UOP |
|---|---|---|---|---|
| 1 | 25,000 | $90,000 | $192,000 | $125,000 |
| 2 | 22,000 | $90,000 | $115,200 | $110,000 |
| 3 | 18,000 | $90,000 | $69,120 | $90,000 |
| 4 | 15,000 | $90,000 | $43,680 | $75,000 |
| 5 | 10,000 | $90,000 | $30,000* | $50,000 |

*DDB Year 5 adjusted so book value = salvage value.

**When to Use Each:**

```mermaid
flowchart TD
    Q["Choose Depreciation Method"] --> SL["Straight-Line
Equal benefit each year"]
    Q --> DDB["Declining Balance
Higher early benefit"]
    Q --> UOP["Units-of-Production
Usage-driven benefit"]
    SL --> SLE["Office buildings
Furniture
General equipment"]
    DDB --> DDBE["Technology assets
Vehicles
Assets losing value fast"]
    UOP --> UOPE["Mining equipment
Aircraft (by flight hours)
Manufacturing machines"]
    style Q fill:#c9a84c,color:#0a0a0f,stroke:#c9a84c
    style SL fill:#1a1a2e,color:#fff,stroke:#c9a84c
    style DDB fill:#1a1a2e,color:#fff,stroke:#c9a84c
    style UOP fill:#1a1a2e,color:#fff,stroke:#c9a84c
```

**Financial Analysis Impact:**
- **Early years:** DDB has the highest depreciation, lowest net income, and lowest asset values. SL is in the middle (constant).
- **Later years:** DDB has the lowest depreciation, highest net income. Pattern reverses.
- **Total depreciation** is the same ($450,000) across all methods — it is only the timing that differs.
- **Tax effect:** Higher early depreciation (DDB) means lower early taxes and higher early cash flows. This is why DDB is preferred for tax reporting.

**Exam Tip:** If a question asks which method produces the highest net income in Year 1, the answer is straight-line (lowest depreciation). If it asks about Year 1 cash flow advantage, the answer is DDB (highest depreciation = lowest taxes).

Practice depreciation calculations in our CFA Level I question bank on AcadiFi.

How do the three depreciation methods compare, and when would a company choose each one?

Master Level I with our CFA Course

Related Questions

Practice Questions