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What exactly is depreciation?

 
Terminology:
Fixed Asset: Property used in a productive capacity which will benefit the enterprise for longer than one year
Depreciation:
The process of deducting the purchase price of a fixed asset over several accounting periods.
Basis:
The full cost of placing a fixed asset in service, used to calculate depreciation expense.
Market value:
What the property could be sold for today.
Book value:
basis less accumulated depreciation
Salvage value:
the estimated sales price of the property at the end of its useful life.
Amortization:
The process of allocating the original cost of an intangible asset to the periods benefited.
Depletion:
The process of allocating the original cost of a natural resource to the periods benefited.
GAAP:
Generally Accepted Accounting Principles.

 Introduction:

Most businesses need to purchase some kind of durable equipment in order to operate. Equipment that lasts longer than one year is called a fixed asset  These assets assist in the generation of revenue over time. For instance, an oven that lasts several years may be used to bake many loaves of bread each day. The oven is integral to the sale of each loaf of bread.

Property such as ovens, furniture, computers, vehicles, and buildings contribute to the operating capacity of a company over many years. Because of this long-term contribution, fixed assets are treated differently than many other business expenses. The purchase price of these fixed assets is typically expensed over a period of years, rather than in the year the purchase was made. This business expense is known as depreciation

Depreciation can be understood in three ways:

  • Popular definition: A decline in the market value of an asset due to wear and tear or obsolescence. A new automobile "depreciates" when you drive it off the lot.

  • Tax definition: A way to recover the cost of a fixed asset through tax deductions. Like other business expenses, depreciation expenses reduce your taxable income.

  • Accounting definition: A means of allocating a portion of a fixed asset's cost to each period that the asset helps generate revenue.

 How will this article help?

Dividing the purchase price of a fixed asset over several years makes your financial picture more accurate. depreciation matches the cost of a fixed asset with the revenues that it helps generate over time. This accomplishes one of the primary aims of accounting to illuminate the costs of doing business by tying expenses to associated revenues.

This article will help you:

  • Calculate and compare different methods of depreciation.

  • Allocate fixed asset costs according to generally accepted accounting principles (GAAP).

  • Maintain a record of depreciation information for each fixed asset.

  • Understand your accountant's recommendations.

This article will help you understand depreciation and make some decisions about it. It's not meant to replace the advice of a good accountant, though you will still benefit from an expert opinion applied to your unique business situation.

This article concentrates on book depreciation, not tax depreciation. Book depreciation is often required or preferred by loan officers, bonding agents, and investors. If your business shares financial information with external parties, you may need to prepare financial statements using this method. Even if you only use financial statements internally, book depreciation can help you get a more accurate financial picture by matching fixed asset costs with associated revenues.

However, you may not need this article if you:

  • Do not have any fixed assets.

  • Don't anticipate acquiring any fixed assets for your business.

  • Prefer to leave decisions about depreciation entirely up to your accountant.

 Tax vs. book depreciation:

The game of accounting uses a very thick rule book. In fact, sometimes it uses two. Tax laws often differ from the generally accepted accounting principles that govern the preparation of financial statements. Why is this?

The purpose of financial accounting is to provide accurate financial data on which to base business decisions. Income tax laws serve a different purpose: they provide revenue for governmental goods and services. Some deductions that are allowable to arrive at taxable income are not allowed under generally accepted accounting principles (GAAP). Because the goals of financial accounting and income tax accounting differ, sometimes their rules differ, too.

This article focuses on book depreciation for several reasons:

GAAP helps you generate accurate data for better business decision making. Lenders, investors, and other third parties often prefer or even require financial statements based on GAAP. Tax laws are amended yearly, whereas accounting principles remain constant. Book depreciation methods are acceptable for tax use, but tax methods are not accepted under GAAP.

Under the rules of financial accounting, fixed asset costs are allocated to the time periods that they benefit. Your financial statements should reflect how your assets contribute to the generation of revenue over time. The depreciation methods presented here allocate a portion of an asset's cost to each year that the asset helps produce income.

Many small businesses enter depreciation expenses only once a year, at tax time. If depreciation figures are off throughout the year, your business planning and decision-making may be adversely affected. 

At this point, you might rightly be wondering how to adjust for the variance between tax and book depreciation. The answer depends on your form of organization. For sole proprietorships, partnerships, and S corporations, the adjustment is already included on ordinary tax forms. C corporations must report the difference on their financial statements in a liability account called Deferred Taxes. For more information about making these adjustments, consult your accountant.

 What property is depreciable?

When you purchase items used to run your business, like office supplies or telephone services, you assign them to an expense account. When you purchase a fixed assets, you assign it to a fixed asset account and expense it over a period of years. Most fixed assets are depreciable. Items that will be used up within one year are not.

The IRS and the Financial Accounting Standards Board both have rules about what kinds of property must be depreciated, and what kinds of property must be handled by other accounting methods. This section explains the generally accepted accounting principles that govern depreciation.

 What cannot be depreciated?

Not all property used in your business can be depreciated. Land retains its usefulness indefinitely, and is therefore not depreciable. Inventory and property that you lease or rent is not depreciable, either. But the cost of permanent improvements to property you lease can sometimes be depreciated. Your accountant can help you understand the rules about these leasehold improvements.

Intangible assets such as patents, trademarks, subscriber lists, and business licenses give your business valuable rights - but they are not depreciable. Instead, they are handled by a method known as amortization  Intangible assets should be amortized on a straight-line basis over their useful life. Only those intangible assets that were purchased can be amortized; those that your business created are neither depreciable nor amortizable.

Depletion is used for natural resources that benefit the business for longer than one year. For instance, coal, sand, and gravel holdings are all subject to depletion rather than depreciation or amortization. Depletion is handled by a method similar to units of production

If you have property that may need to be depleted or amortized, ask your accountant for details.

What amount gets depreciated?  

All the costs required to make an asset usable to a company are included in an asset's basis You must enter the basis for each asset for which you calculate depreciation. To determine basis, add up all the costs to place this asset in service. Include:

  • Asset cost

  • Sales tax

  • Shipping and delivery

  • Installation charges

  • Other incidental costs without which the asset would not be of service to your business

If you use the asset for both business and personal purposes, you will need to identify what portion is used for business purposes in order to determine basis.

You should check with your accountant if you make improvements or additions to an asset after its original purchase. Substantial changes can change the asset's basis.

If you acquired property by gift, or converted personal property to business use, other rules apply. Check with your accountant.

 Assets used at home and work:

You are not allowed to depreciate personal assets used outside of your business, like the family car or your personal computer. However, you can depreciate a portion of a mixed-use asset, such as a vehicle used for both business and personal trips. This rule applies to all kinds of property, not just autos.

To determine what portion of a mixed-use asset you can depreciate, you must figure out what percentage of its use is for strictly business purposes. This allocation is ordinarily made based on the amount of time the asset is used for business, versus the amount of time it is used for personal reasons.

For some assets, time is not the most appropriate measure. For example, if you own your home and use a portion of it exclusively for business activity, you may be able to depreciate some of its cost. The depreciable amount is based on the percentage of square feet used for business. For a vehicle, keep a mileage record that shows the number of miles you drive for business purposes.

 Methods of depreciation:

The depreciation method you choose affects your annual depreciation expense. Over time, each method allows you to depreciate approximately the same dollar amount. But while the end result is the same, annual depreciation amounts may differ significantly under different methods.

Take an item with a $1000 depreciable value. Different methods may require you to depreciate:

  • Straight Line: $100 each year for 10 years

  • Sum of the Years' Digits: $182 in the first year, and declining amounts for each of the next 9 years.

  • Double-Declining Balance: $200 in the first year, and declining amounts for each of the next 9 years.

  • Units of Production: Varying amounts each year depending on usage

You can choose a different method of depreciation for each asset you own. The method you choose will depend on the type of property and the needs of your business. For some kinds of assets, an accelerated method of depreciation will be more appropriate. For others, you may wish to keep it simple and expense the same amount each year.

 Straight line:

Why use this method?

Straight-line (SL) depreciation is the most commonly used depreciation method; it's also the simplest. It can be used for both book and tax depreciation. Under straight-line depreciation, the cost of a fixed asset is spread in equal amounts over its estimated useful life.

This method assumes the asset provides constant benefits. If an asset is expected to be used in the business for 10 years, then each year 1/10 of that asset's depreciable value is expensed. The dollar amount of depreciation remains constant from year to year.

This is how it works:

Annual depreciation expense

 =

cost less salvage value


estimated useful life

 

 

 

 Sum of years' digits:

Why use this method?

Sum of the years' digits (SYD) is a method of accelerated depreciation. Accelerated methods assume a fixed asset  loses a greater proportion of its value in the early years of use.

Consequently, the amount of depreciation expense is higher at the beginning of the useful life, and declines over time. 

Some kinds of property - cars, for instance - are more efficiently productive in the initial years of use. Over time, they become more costly to maintain. Rising maintenance and repair costs tend to offset the lower depreciation expense in later years. Property with this characteristic makes a good candidate for an accelerated method. 

SYD depreciates more in the early years than straight-line does, but it's not as accelerated as the double-declining balance method. 

This is how it works:

Sum of years digits

 Double Declining Balance:

Why use this method?

Double declining balance (DDB) is a method of accelerated depreciation. Like sum of the years' digits, it's a good method to use when the productivity of an asset is expected to be greater during its early years of use. 

DDB is a more accelerated method than sum of the years' digits. It yields a higher depreciation expense early on, and declines more dramatically. The one you choose will depend upon the most logical way to allocate costs for a particular asset. 

It can be advantageous to begin depreciating under DDB and switch to the straight-line method some years into the asset's useful life. Your accountant can help you understand whether this method is right for you. 

This is how it works:

Double declining balance 

 Units of production:

Why use this method?

The units of production (UOP) method allocates depreciation expenses according to actual physical usage. Assets with an indefinite useful life but a limited productive capacity are good candidates for this method. The UOP method is particularly appropriate when the usage of a fixed asset varies greatly from year to year. 

For example, the blade of an industrial circular saw might be good for 10,000 hours of use, but it could take seven years, ten, or even fifteen to use up those 10,000 hours. In this case, the useful life is not clear, but the total productive capacity is. Or, the saw might be used for 5,000 hours in the first two years, and only sporadically for the next three. The UOP method helps solve these problems by allocating the cost of the saw blade to the accounting periods in which it is actually used. 

Units of production relies on an estimate of the productive capacity of the fixed asset. GAAP requires a "systematic and rational" estimate of the number of units - be they hours, products, miles, or another measure - that the property will produce. 

To find the depreciation expense for a year, a quarter, or a month, multiply the number of units produced during that period by the UOP rate.  

This is how it works:

Units of production 

 Income tax depreciation:

You may hear your accountant mention MACRS, (Modified Accelerated Cost Recovery System) ACRS (Accelerated Cost Recovery System), or Section 179. Each of these is an accelerated depreciation method set forth by income tax law. The method used depends in part upon the type of property and the year that it was placed in service. 

Income tax rules are not guided by the accounting concepts that apply to depreciation for financial reporting. Hence, MACRS, ACRS, and Section 179 are not acceptable under GAAP. The IRS's greatly accelerated depreciation methods do not accurately match costs to revenues. However, they allow you to take larger tax deductions in the early years of asset ownership.

Section 179 is of particular relevance to small businesses. It allows a deduction for the entire cost of a fixed asset in the year of acquisition. This can amount to a significant savings in the up-front cost of a fixed asset purchase. Certain limitations apply. 

While IRS methods cannot be used for book depreciation, the book methods described in this article are acceptable for tax use. However, only an accountant can tell you which method will provide the most tax benefit. 

 How long does depreciation last?

Depreciation depends on estimates of the useful life of each asset and its worth upon disposal. Since it is hard to predict exactly how long each asset will be used in your business, you must approximate how long an asset will contribute to revenue generation. There are also rules about when you can begin depreciation, and when you must stop. These generally accepted accounting principles help standardize the process of depreciation and ensure that it's done correctly.

 When does depreciation begin?

Depreciation begins during the month or year that you start using an asset productively in your business. You cannot record a depreciation expense for an asset that has been purchased but not yet used. For instance, if you are waiting for delivery of a prepaid computer, you cannot begin recording depreciation expenses until you actually start using it. The date on which you begin using a fixed asset in your business is known as the "placed-in-service" date. This date is required in order to figure the correct depreciation expense.

 Partial years depreciation: 

It is imprecise to take a full year's depreciation when an asset has only been in service for part of a year. When a fixed asset  is acquired or disposed of mid-year, the full-year depreciation amount is prorated according to the amount of time the asset has been in service. There are several simplified conventions used to do this.

The convention you choose affects the amount of depreciation in the first and last accounting periods. In choosing a convention, consider these criteria:

  • Which convention best links the expense with its associated revenues?

  • Which convention is simplest to use?

  • Is it advantageous to take more depreciation in the first year of service?

  • Which convention is most closely associated with the date the asset was placed in service?

You can choose any convention, regardless of the date placed in service. Many companies choose the Full Year convention for simplicity. An accountant can help you decide which convention is best to use in your circumstances. 

Conventions:

  • Full Year: Record a full year's depreciation in the first year and none in the last.

  • Half Year: Record half of one year's depreciation in the first year and half in the last.

  • Full month: Depreciation is prorated according to the number of months in service during the year, including the month placed in service.

  • Half Month: Depreciation is prorated according to the number of months in service during the year. The month the asset is placed in service is included only if the placed-in-service date falls on or before the 15th.

  • Actual days: Depreciation is prorated according to the number of days in service during the year.

 An assets useful life:

Depreciation amounts are based in part upon an estimate of the useful life of a fixed asset. In accounting terminology, this is known as the recovery period. 

It's common practice for accountants to use recovery periods published by the IRS as a guideline, even when doing book depreciation. GAAP allows you to depart from these recovery periods if you expect the useful life to be a few years more or less than what the table says. The maximum allowable useful life is forty years. The minimum is one. 

The table below was compiled from a list of recovery periods that the IRS allows. Find the useful life for your asset in this table, or refer to Appendix B of IRS Publication 946 for additional guidance on estimating useful life. 

Useful lives of common assets

Asset Type:   Years:
     

Office furniture & Equipment

  7

Computers, typewriters, Calculators, Copiers

  5

Automobiles & Trucks

  5
Trailers   3
Tractors   5

Vessels, barges, tugs, and similar water transportation equipment

  10

Assets used in manufacture of apparel and textiles

  5

Assets used in manufacture of wood products and furniture

  7

Assets used in construction activities

  5

 When does depreciation end?

You must stop claiming depreciation as soon as:

  • The estimated useful life is up.

  • You stop using the asset in your business.

  • You sell or otherwise dispose of the asset.

  • Book value equals salvage value 

 You may not depreciate an amount greater than the salvage value of the asset. To determine salvage value, make a reasonable estimate of what the asset will be worth at the end of its useful life. 

An asset should remain on the books until it is disposed of, even if it has been fully depreciated. When an asset is disposed of, you must remove the book value of the asset from your chart of accounts. Rarely is an asset sold or otherwise disposed of for the same dollar amount as the book value. When the sales price exceeds book value, you must record a gain. When the sales price is below book value, record a loss.

 

 

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