The Straight-Line Depreciation Method Used by Selected Companies and Educational Institutions in the Philippines

Transcription

1 Journal of Modern Accounting and Auditing, ISSN April 2013, Vol. 9, No. 4, D DAVID PUBLISHING The Straight-Line Depreciation Method Used by Selected Companies and Educational Institutions in the Philippines Venus C. Ibarra University of Guam, Guam, USA Ateneo de Manila University, Quezon, Philippines San Pablo Colleges, San Pablo, Philippines The straight-line method in computing for depreciation expense is the prevailing method used in the Philippines. This paper aims to determine the rationale behind the use of this method. The objective of the study is to determine the length of time within which the depreciation method is used, reasons in using the method, the rate of depreciation used by the companies, and the effects of the depreciation expense on their operating expenses. It also determines if the companies decisions to use the straight-line method are influenced by the factors mentioned by Reynolds (1961) expected amount of services over the life of assets, the amount and timing of operating costs, the decline in the physical efficiency of the assets, and the rate of return and if they considered capital investments and tax reduction in using this method. The study shows that companies and educational institutions use the straight-line method of computing depreciation expenses, because it is easy to use in computing the depreciation expenses, in comparing with previous years computations, and in keeping track of the expenses. It is also convenient for tax administration and financial reporting. The rate of depreciation used varies, because the companies and educational institutions use their past experiences in determining the life of fixed assets. The percentage of depreciation to the operating expenses also varies. The companies and educational institutions adhered to the factors mentioned by Reynolds (1961) in choosing the straight-line method of depreciation. The companies did not consider reduction of tax in using the straight-line method. Keywords: straight-line method, depreciation method, depreciation rate Introduction Depreciation is the systematic allocation of the cost of long-lived assets to periodic expense over the life of the asset. It is the reduction of the value of an asset due to eventual wearing out. As assets are capitalized and used for the benefit of the firm, they gradually wear down until they eventually become unproductive (J. D. Stice, E. K. Stice, & Skousen, 2007). Depreciation of capital assets is needed in accounting for two reasons. One is that the asset is coming closer to the end of its useful life. The older the asset, the fewer years it has left to produce income. Another This paper was presented at the 3rd Annual Conference of the World Accounting Frontiers Series, Incorporating the International Conference of Accounting, Business, Leadership and Information Management, May 18-21, 2011, University of Macau, Macau Special Administrative Region (SAR), People s Republic of China. Venus C. Ibarra, associate professor of Accounting, University of Guam; affiliated with JC School of Management, Ateneo de Manila University, and San Pablo Colleges. venus.ibarra@yahoo.com.

2 THE STRAIGHT-LINE DEPRECIATION METHOD 481 reason is that due to wear and tear, older assets decline in productivity and would require higher repair and maintenance costs as compared with newer assets (Department of Treasury, 2009). Different companies use different types of depreciation methods. These methods approximate the actual pattern of usage of an asset. The methods could be divided into time-factor methods which are based on the passage of time and the use-factor methods which are based on the amount of output that the assets produce. Time-factor methods consist of straight-line depreciation and accelerated methods, namely, sum of the years digits and declining-balance methods. The use-factor methods consist of service-hour depreciation and units of production depreciation. Each method records depreciation differently and affects expenses related to the depreciable assets. The straight-line method of depreciation is calculated by subtracting the salvage value from the total acquisition price of the asset divided by its useful life, which is the number of years that the asset can benefit the company (Kennon, 2009). On the other hand, the accelerated depreciation, like the declining balance method of depreciation and sum of year s digits method, calculates the depreciation by allocating a larger part of the cost of the fixed asset to the beginning of its life. This characteristic of depreciation makes it rather popular with companies that intend to reduce their income taxes. Since taxes are computed based on net income, reducing the net income through a non-cash expense results in a lower tax expense. Depreciation is allocating the asset s cost over its useful life. How companies compute and record depreciation will affect their financial statements. Recording depreciation as an expense will reduce the net income and in turn affect the amount of taxable income. Thus, depreciation expense may substantially affect the income of an organization. This is the reason why most discussions on depreciation methods have focused on the effects of using the straight-line method for reporting purposes and the use of accelerated depreciation for tax purposes. Choosing the depreciation method for a company may at first seem like a harmless choice, but it is this choice that causes the increase and decrease in taxes charged to a company and causes managers to make either inefficient or value-maximizing capital investment decisions (Jackson, 2008). The tax system based on income generally does not allow a deduction for the cost of an asset in the year in which it is purchased. Instead, it spreads out the deduction over a period roughly consistent with the asset s useful economic lifetime. This is because that the value of a capital asset does not end after the year when it is purchased. Therefore, if the firm is allowed to deduct the full cost of the asset during the year when it is purchased, the income would have been understated (Department of Treasury, 2009). Accelerated depreciation methods like the double-declining balance method are usually chosen by firms in considering the income tax charges, because accelerating deductions is a basic tax-minimizing technique, resulting in lower income taxes (Messere & Zuckerman, 1981). A company must be able to identify the cost of the asset, its useful life, and its residual value to be able to estimate its depreciation. Moreover, the kind of depreciation method used also affects the repair and maintenance expenses of the company as related to depreciable assets. The accelerated depreciation methods will be able to balance out or equalize the repair and maintenance costs of the asset in the latter years, when it has undergone wear and tear by having already deducted a bigger and most of the depreciation in earlier part of the asset s life. These methods will balance the rapid reduction of value for items that become obsolete quicker (Schwanhausser, 2005).

3 482 THE STRAIGHT-LINE DEPRECIATION METHOD Review of Related Studies and Literature Depreciation methods have always been a controversial topic in accounting. One major dilemma is estimating the true value assets used up by a company in generating profits. An accurate estimate of the depreciation expense means a more accurate income statement which investors and creditors depend on for their decisions. There will be instances when the income statement can be overstated or understated. Use of unreliable data in estimation of the assets value, useful life, rate of depreciation, and residual value are some factors that contribute to the inaccurate depreciation expense. It is important that entities select the proper depreciation method for certain types of asset in order to be able to apply the true definition of depreciation. Authors and studies differ in their views on what type of depreciation method is more efficient or has the true definition of deprecation. Kohler and Morrison (1926) focused on the straight-line method because of its almost universal use. In 1934, the United States Treasury passed a decision specifying the use of straight-line method and the units of production method in computing for the depreciation expense. However, it was the straight-line method that was commonly used instead of the units of production method. For his part, Grady (1950) advocated the use of production method, especially for those companies involved in manufacturing. He encouraged the use of units of production method, because it accurately reflected the true nature of businesses engaged in the production of goods. While the straight-line method allocates the cost of the fixed asset over time only in relation to the mere passage of time, the production method yields a more appropriate and ratable charge of exhaustion of the fixed assets in relation to their use. It is more appropriate to delegate the costs of the fixed assets to the units they produce rather than relating them to calendar months or calendar years. Furthermore, the production method caused depreciation expense to be higher during periods of highly productive business activities and a lower depreciation expense in period of relatively low activities. Grady (1950) asserted that the production method, which mirrored the trend of business activity, was a tool in lowering net income for periods of high net cash flows and eased the burden of fixed charges in periods of depression. It is quite clear then that the type of depreciation method used makes a difference for companies. Before the promulgation of tax and accounting laws, each company decided on their own whether or not to charge a depreciation expense for the year, based on their preferred level of income. In 1954, with the New Internal Revenue Code, two other depreciation methods were officially recognized: the sum of the years digits and the double-declining method. According to Reynolds (1961), the following should determine the depreciation for a group of homogeneous assets: (1) the amount of services in terms of volume and earnings that may be expected of the asset over the years; (2) the amount and timing of the operating costs that may be incurred over the life of the asset; (3) the impairment of service quality and adequacy, as evidenced by the decline in physical efficiency of the asset; (4) the amount of competition which may be expected from improved substitutes; and (5) the implicit rate of return which the type of asset earns. In 1967, a study reviewed firms that took advantage of the accounting rules that permitted the change of depreciation method from one to another (Myers, 1967). Eighteen out of 19 companies that changed from accelerated method to the straight-line method reported an increase in earnings. Another company that lengthened the depreciable life of the assets also saw an increase in earnings. These resulted in a large drop in their depreciation expenses.

4 THE STRAIGHT-LINE DEPRECIATION METHOD 483 In another study, Ronen and Srinidhi (1989) mentioned that in the case of a uniform continuous age distribution of capital, a class of methods which included the straight-line method was optimal, but other widely accepted depreciation methods were not. If a discrete life distribution (with a year as the unit of time) was assumed, a straight-line depreciation was shown to be sub-optimal. A study showing accounting trends of 600 stockholders reports in the United States was conducted by the American Institute of Certified Public Accountants (AICPA) in The survey shows that only a handful of firms used accelerated methods for income tax reporting. The study initiated the necessity of disclosing the depreciation expense and method used, as well as the accumulated depreciation in the balance sheet. The choice of depreciation method has implications for companies. To cite an example, Jackson (2008) showed that managers of firms that used straight-line depreciation were less likely to invest in a replacement asset than managers of firms that used accelerated depreciation. Theoretically, replacing an existing asset will yield higher cash flows; but on the other hand, the replacement of the asset will cause earnings to be lower due to the bigger remaining book value under the straight-line depreciation relative to accelerated depreciation. Since most companies and corporations emphasize achieving a certain earnings target, firms that use straight-line depreciation tend not to replace assets, due to its lowering of earnings. Thus, these considerations may push the managers to make inefficient capital investment decisions. One implication of this is that although straight-line depreciation is easier to compute, accelerated depreciation may lead to more efficient capital investment decisions. This study focuses on the straight-line method and aims to determine the rationale behind the use of this method. The objective of the study is to determine the length of time within which the depreciation method is used, reasons in using the method, the rate of depreciation used by the companies, and the effects of the depreciation expense on their operating expenses. In addition, it aims to determine whether their decisions are influenced by some of the factors mentioned by Reynolds (1961). Have they considered capital investments in their choices of depreciation method? Have they considered reduction of tax in their choices of depreciation method? Descriptive-survey research method was utilized in the study. This study surveyed 26 manufacturing companies and four educational institutions in the Philippines for a total of 30 respondents. The respondents include chief executive officers, finance officers, accounting officers, and chief accountants. Interviews were conducted via phone or in person, and follow-up questionnaires were sent through s and faxes. Lists of companies were provided by Bureau of Internal Revenue (BIR) and DTI 1 -Laguna provincial office. Respondents were limited to those that were willing to be parts of the study. Manufacturing companies were selected purposely based on their proximity to Metro Manila. Likewise, all four educational institutions, located in Laguna, were purposely selected for easy access. All respondents are top manufacturing companies and educational institutions in their respective areas. The respondents are diverse: 20 companies are engaged in retailing or manufacturing non-food products, drugs and medicines, and food and beverages, three respondents are from oil and coco by-products manufacturing, three from the jeepney assembling sector, and four come from educational institutions. All respondents who were willing to be parts of the study were interviewed. Respondents were not chosen based on their answers to what kind of depreciation method does your company/institution use?. All 1 Department of Trade and Industry.

5 484 THE STRAIGHT-LINE DEPRECIATION METHOD respondents, however, used and are still using the straight-line method of depreciation. Only one manufacturing company uses two depreciation methods. This company uses a number of units produce or output in depreciating manufacturing equipment and manufacturing tools and straight-line method in deprecating building, service vehicles, and office furniture and fixtures. All respondents requested that their companies/educational institutions should not be revealed in this study. Presentation of Data All 26 companies and four educational institutions used the straight-line method of depreciation, despite the availability of other depreciation methods. One manufacturing company combined two depreciation methods. All respondents agree that the straight-line method is simple and convenient to use and that depreciation expense is easy to compute, compare, and keep track. The method is easy to use for tax administration and financial reporting. One of the companies also points out that they are using the straight-line depreciation method, because it is what their international branches are using. The companies and educational institutions have been using this method since the start of their businesses. The companies and educational institutions do not have plans to change the current method of depreciation they are using. They believe that the straight-line method is the most efficient one in determining the depreciation expenses. Table 1 shows the number of years within which the companies estimated the life of their fixed assets. Table 1 Yearly Rate of Depreciation of Companies Using Straight-Line Method (n = 26) Type of asset No. of respondents Estimated life Rate of depreciation (%) Building (other than factory) Building improvements 0 Below to 15 7 to to 20 5 to 10 0 Below to 20 5 to to 30 3 to 10 0 Below 5 Land improvements 3 5 to 15 3 to to 20 5 to 20 Factory building 26 5 to to 20 Machinery 3 5 to to to 15 3 to 20 Tools 26 3 to 5 20 to 33 Transportation equipment Office equipment 26 5 to to 20 Office furniture 3 5 to to to 15 3 to 20 The rate of depreciation used by companies varies. The companies used their past experiences in determining the life of a fixed asset. The estimated life of a building ranges from 10 to 20 years, while building improvements are estimated to be higher than building, which is up to 30 years. The estimated number of years (five up to 10 years) in using factory building is lower than building (other than factory) and building improvements, because factory building deteriorates faster than the ordinary building. The life of land

6 THE STRAIGHT-LINE DEPRECIATION METHOD 485 improvements is estimated from five to 20 years, machinery from five to 15 years, while the life of tools is from three to five years. All companies estimated the life of their transportation equipments at five years. Office equipment has shorter life from five to 10 years as compared with office furniture (five to 15 years). Table 2 Yearly Rate of Depreciation of Educational Institutions Using Straight-Line Method (n = 4) Type of asset No. of respondents Estimated life Rate of depreciation (%) Building 4 10 to 20 5 to 10 Building improvements 4 10 to 30 3 to 10 Land improvements 4 5 to 20 5 to 20 Transportation equipment Office equipment 4 3 to to 33 Office furniture 4 3 to 15 7 to 33 School equipment 4 3 to 5 20 to 33 School furniture 4 3 to 5 20 to 33 All respondents from the educational institutions gave the same responses on the estimated life of fixed assets that they used. The life of the building is estimated from 10 to 20 years, while building improvements range from 10 to 30 years. Land improvements range from five to 20 years. The estimated life of transportation is five years. Office equipment has a shorter life span from three to 10 years, while office furniture ranges from three to 15 years. Due to constant use by students, school equipments and furniture were estimated to last from three to five years only (see Table 2). Percentage of depreciation expense to operating expense also varies. Table 3 shows the responses of the respondents. Five companies did not indicate any percentage. Table 3 Percentage of Depreciation Expense to Operating Expense (n = 30) Percentage (%) No. of respondents Type of respondents 2 2 Education 3 2 Education 4 2 Jeepney 7 2 Jeepney/manufacturing 8 2 Manufacturing 10 2 Manufacturing 12 2 Manufacturing 13 2 Manufacturing 15 2 Manufacturing 20 3 Manufacturing 27 2 Manufacturing 30 2 Manufacturing No answer 5 Manufacturing It should be noted that the percentage of the depreciation expenses to the operating expense has no trend, with no pattern across the companies. It ranges from a low of 2% to a high of 30%. However, the educational institutions are showing a range of 2% to 3%. The effect of the depreciation expense to the total operating expense is probably affected by the estimated life of the fixed assets. Factors considered in choosing the straight-line method of depreciation are shown in Table 4.

7 486 THE STRAIGHT-LINE DEPRECIATION METHOD Table 4 Factors Considered in Choice of Depreciation Method (n = 30) Factor Yes No No answer Expected amount of services over the life of assets The amount and timing of operating costs The decline in the physical efficiency of the assets Rate of return which the type of assets earns Capital investments Reduction of tax When asked about the factors they considered in their choices of depreciation method, respondents unknowingly used Reynolds (1961) factors in using the straight-line method in depreciating their fixed assets. All companies and educational institutions believed that the amount of services in terms of volume and earnings that might be expected of the asset over the years was a consideration. Explicitly, the estimated life of the fixed assets was based on their past experiences. The amount and timing of the operating costs that might be incurred over the life of the asset were taken into consideration when they determined the expected life of the fixed assets, and the decline in physical efficiency of the asset was considered by all of the companies. The rate of return which the type of asset earns was considered by 15% or 50% of the companies. Three educational institutions said that they could not compute the rate of return of their assets, and three companies and one educational institution gave no answer. Twenty four or 80% considered their capital investments, three educational institutions did not consider capital investments, and another company gave no answer. Tax is a sensitive topic for most companies. The BIR advocates the consistent use of one method. Twenty-one companies or 70% no responses confirmed that they did not consider tax reduction in their choices. Only six companies or 20% indicated that they might have taken tax into consideration, and three companies or 10% did not give an answer. Summary of Findings Different methods of depreciation allow a company to record depreciation expense in relation to depreciable assets differently, reflecting differences in financial statement data. The straight-line method is the most commonly used depreciation method among all the other methods. The study shows that although there are several depreciation methods available for companies to use, all of them still choose to use the straight-line depreciation method. The reason given for using the straight-line method of depreciation is that it is convenient, practical, simple, and easy to use in computing depreciation expenses. The companies and educational institutions have been using this method since the start of their businesses or schools. None of the companies or educational institutions intends to change this method in the near future. The rate of depreciation used varies. Aside from past experiences, the companies and educational institutions do not have other bases for estimating the life of the fixed assets. The companies and educational institutions surveyed adhered to the factors mentioned by Reynolds (1961), namely, expected amount of services over the life of assets, the amount and timing of operating costs, the decline in the physical efficiency of the assets, and the rate of return which the type of assets earns in choosing the straight-line method of depreciation. The companies and educational institutions do not consider reduction of tax in their choices of depreciation method.

8 THE STRAIGHT-LINE DEPRECIATION METHOD 487 Analysis and Conclusions The straight-line method of depreciation is the most common depreciation method used by manufacturing companies and educational institutions. While it is simple, popular, and used by all the companies in this study, the question is whether the straight-line depreciation method is the most appropriate way of calculating depreciation or not, especially for manufacturing firms. The answer lies in understanding that depreciation is a process of allocation, not valuation. The pattern of annual depreciation charges for a fixed asset should attempt to match the pattern of benefits derived from that asset. When the benefits from an asset are likely to be reasonably constant over its life, the straight-line method of depreciation would be appropriate, as it results in a constant annual depreciation charge. However, this does not mean that the other depreciation methods are not significant or cannot be used, just because all of the selected manufacturing companies and educational institutions are using the straight-line method of depreciation. This may just imply that this particular method of depreciation works best for them when considering the simplicity and convenience of using the method. However, in choosing the straight-line method, they may have forgone the chance to minimize taxes. There are differences in estimating the life of the fixed assets that may have an impact on the total operating expenses. In the straight-line method of computing depreciation expense, the lower number of years, the higher the depreciation expense is; conversely, the higher the number of years, the lower the depreciation expense. This will directly affect the net income of a company. This is a big concern, since the majority of the respondents are in manufacturing and should be showing almost the same estimates for reliability, comparison, and tax purposes. A listed manufacturing company, for example, will have a more positive-sounding financial statement, if the estimated life of its fixed assets is 30 years, but this does not necessarily provide a true picture of the company. Recommendations Since it can be seen from the study that the straight-line method of depreciation is widely used by manufacturing companies and educational institutions, the researcher suggests further studies on this method and its effects on the net income of manufacturing companies and educational institutions. Tax authorities should impose a standard estimated life for the different types of fixed assets. These will be used in computing for the depreciation expenses to be shown in the income statements. The companies as well as educational institutions will not have the chance to manipulate their depreciation expenses to show lower income or better income for tax purposes or for attracting investors. In presenting the income statement, net profit before non-cash expenses (including depreciation) should be shown before profits from operations. In this way, prospective creditors and investors are shown the results of operation before any management-influenced expenses like depreciation and bad debts are deducted from the gross profits. This will of course affect the computation of costs of goods manufactured, since depreciation expenses of factory building, equipment, tools, machinery, and the like are included in the factory overhead. Furthermore, the researcher recommends that further studies be done on the uses of other methods of depreciation. The study should be able to recommend the appropriate type of depreciation method that a particular industry or sector can use to enable users to compare and evaluate financial statements of companies in the same industry or sector.

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