Straight-Line and MACRS Method

Financial Reports and the IRS -- Accounting for Depreciation


A company may choose to use the straight-line method for depreciating assets on their financial statements, but this method is not correct for income tax purposes. The straight line method of depreciation for financial reporting purposes is an acceptable method according to generally accepted accounting principles (GAAP), but the Internal Revenue Service requires that companies use the Modified Accelerated Cost Recovery System (MACRS) to compute depreciation for income tax purposes.

Straight-Line Method

The benefits of using the straight-line method for book purposes are that it is simple and easy to use, and is a fairly reasonable transfer of costs for financial reporting purposes. A simple spreadsheet is all that is required to use this method. An accountant simply calculates the depreciable cost of the asset, and divides this amount by the estimated useful life. The entry can be recorded monthly on the books for financial reporting purposes by debiting depreciation expense and crediting accumulated depreciation.

As an example, if a company purchased a light-duty truck to use in their business at a cost of $20,000, with an estimated residual value of $5,000 at the end of five years, the depreciable cost would be $15,000 ($20,000-$5,000). Divide this by the five year useful life and the monthly entry for this would be a debit to depreciation expense-company vehicles for $250 ($15,000/5=$3000/12), and a credit to accumulated depreciation-company vehicles. At the end of the year, the financial statement would reflect a total expense of $3,000 for depreciation expense-company vehicles. Therefore, the net income on the financial statement of the company would be reduced by $3,000 each year for five years using the straight-line method.

MACRS Method

For tax purposes, the MACRS method should be used. According to the IRS, the two most common asset classes besides real estate are the five-year and the seven-year asset class. Asset classes are similar types of assets grouped together. The five-year asset class includes automobiles and light-duty trucks, while the seven-year class includes most machinery and equipment, which means that all automobiles and light-duty trucks should be depreciated for five years, and most machinery and equipment should be depreciated for seven years. When using the MACRS method, the residual value is ignored. All fixed assets are assumed to be put in and taken out of service in the middle of the year. Therefore, for the five-year class assets, depreciation is spread over six years. The depreciation rates for the five-year class are as follows:

  • Year 1---20.0%
  • Year 2---32.0
  • Year 3---19.2
  • Year 4---11.5
  • Year 5---11.5
  • Year 6---5.8

These total 100%, and at the end of year 6, the asset will be fully depreciated. Using the MACRS method with the example above, the depreciation computed for tax purposes in year 1 is $4,000 ($20,000x20%). The straight line method for year 1 is $3,000; therefore the MACRS method reduces taxable income by an additional $1,000 in year 1. It isn't until Year 4 that the MACRS method produces a lower depreciation deduction than the straight line method.

Not only is the MACRS method required for tax purposes by the IRS, it can be more beneficial to the company because it reduces taxable income which in turn reduces the tax liability of the company. It is acceptable for a company to use the MACRS method for both financial statement and tax purposes, but only if it does not result in significantly different amounts than would have been reported using other GAAP methods such as the straight-line method, or the double declining balance method.

However, using the MACRS method for financial reporting purposes may not be the best choice. Showing a profit on financial reports to shareholders and stakeholders is an important goal for any business, and the MACRS method reduces net income more significantly than other methods in the first few years of an assets life. This is one of the reasons that many businesses choose to use other methods for depreciation on the financial reports, and then adjust the depreciation expense on the income tax return to reflect the MACRS method required by the IRS.

Even though GAAP provides for uniformity in financial reporting, different rules may exist for tax purposes. Therefore, it is possible for the financial reports of a company to differ from the tax returns prepared for the IRS because of the use of different accounting methods. In order to comply with both the requirements of GAAP and the IRS, it may be necessary to consult with a competent tax accountant or CPA.

By Justin Millier

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