Discuss the factors a firm considers when choosing among the alternative depreciation and amortization methods

Answer 1

FACTORS IN CHOOSING THE DEPRECIATION AND AMORTIZATION METHOD

Depreciation and amortization affect both net income reported in the financial statements and taxable income on tax returns. Taxing authorities in most jurisdictions specify allowable depreciation methods for tax reporting. When permitted to do so by the taxing authority, firms often use different depreciation methods for financial and tax reporting. When this happens, the difference between depreciation expense in the financial statements and the depreciation deduction on the tax return leads to an issue in accounting for income taxes.

Tax Reporting

If permitted a choice of depreciation methods for tax reporting, a firm should try to maximize the present value of the reductions in tax payments from claiming depreciation. When tax rates stay constant over time and the firm is sufficiently profitable to benefit from tax deductions, earlier deductions have greater value than later ones because taxes saved today have greater value than taxes saved tomorrow. When taxing authorities permit a choice among alternative depreciation methods, a firm should choose the alternative that allows it to pay the least amount of tax, as late as possible, within the law.

Financial Reporting

The objective of financial reporting for long-lived assets is to realistically measure the expiration of the assets' benefits and provide a reasonable pattern of cost allocation. However, the cost of the long-lived asset jointly benefits all the periods of use, and there is no single correct way to allocate such joint costs. As a consequence, authoritative guidance requires that financial statements report depreciation charges based on reasonable estimates; in practice, the straight-line (time) method is the most common.