Question

 The Raincloud Inc. is in the paper products industry. Industry being very capital intensive has been using straight-line depreciatign as the industry standard. The Raincloud Company is contemplating the purchase of a large milling machine that will cost $3 million. The machine will probably have a useful life of ten years, at which time the machine's salvage value will be negligible. However, the machine is the most productive in its first five years. After that, increasing repairs and maintenance requirements will increase the machine's downtime and decrease its efficiency. Prior experience indicates that repairs and maintenance expense will be $40,000 in the first year and will increase at a rate of 10% per year.

 a) I am concerned that if I use double-declining balance depreciation, the earnings of the company, especially in the early years, will not look good in comparison with those firms using straight-line depreciation. Since the sale of the company in the near future is debated among the shareholders, how will a potential buyer view our earnings, in comparison with those of other companies in the industry?

Answer 1

The method of depreciation for a particular asset class is chosen based on the asset and how it getting used in the business. Since the new machine has high usage in the first 5 years the wear and tear of asset is high and the method of depreciation selected should represent the same depreciation expense. Hence the Double declining balance method selected is correct since it charges higher depreciation with double the straight line method rate and has higher depreciation expense in initial years .

The method of depreciation selected by a firm is an Accounting policy. The accounting policy should be applied consistently from year to year basis and should be disclosed as part of the notes to the account. The depreciation policy of the firm can be different from the industry as long as the firm is applying right depreciation method consistently across the years.

Based on the above, the potential buyer will be aware of the depreciation rate and method used by the firm based on depreciation policy. The potential buyer will have this in mind while evaluating the purchases of business and depreciation will adjusted to reflect the comparable earnings. Also it should be remembered that the total depreciation charge is same under both the methods over the life of the asset.