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Understanding Depreciation - A Brief Look at Depreciating Assets for Business and Tax Purposes

By Edited Dec 9, 2013 0 0

Depreciating assets (also called fixed asset depreciation) is not a commonly understood process in the non-business community. Many people are familiar with the term 'depreciation'. One example that often crops up relates to how much an automobile depreciates once it is driven off the lot. The meaning behind this example is that the car is now worth less (i.e. it is no longer a new car, but a used car). In the business world, however, depreciation is actually related to a different concept. It is not meant to represent valuation (what is commonly called fair market value), but is actually a method of cost allocation. Confused? The difference becomes easily understood with a bit more guidance. With a bit of guidance the advantages of fixed asset depreciation and depreciating assets will become apparent.

When a business purchases an asset (long or short term), it places the asset on the books at cost. The business then expenses a short-term asset and depreciates a long-term asset (often called a fixed asset). What is the difference? A short-term asset is expected to be used in one year or one operating cycle whereas a long-term asset (generally property, plant and equipment) will provide benefits for several periods. Depreciating assets is what allows a business to follow the General Accepted Accounting Principles (GAAP) for matching revenue to expenses.

A short-term asset is used up quickly. Paper, pens, envelopes and things of this nature are generally totally expensed in one cycle. This matches the GAAP principle. The benefit is gone and so the expense is total. This is the reason that depreciating assets is limited to fixed assets: matching cost to benefit.

A long-term asset is not so easy. How much benefit does a truck provide this year versus next year to a business? What about a building? A machine? Even though the cost of an item may be paid for in a lump sum, GAAP wants the expense of the item to match the total revenues as evenly as possible. A machine may make money for a business for ten years; therefore, the cost of the machine should be spread out over ten years. The IRS also wants long term asset cost spread out over a longer time. Imagine if a company buys a $10 million dollar machine. This would drop the total taxable net income for that company by $10 million dollars and lower the tax bill to the IRS. Does this make the government happy? NO!!

depreciation calculation

Straight-Line Method of Calculating Fixed Asset Depreciation

How is fixed asset depreciation calculated? There are many accounting methods to calculate depreciation: straight-line depreciation, declining balance, double declining balance, etc. For the purposes of this brief guide, the straight-line method will be easiest to demonstrate, but the other methods are important and worth investigating as well. Before any calculation can begin, it is important to know a handful of terms:

  • Cost – Amount paid for the asset.
  • Salvage Value – What the asset can be sold for at the end of its useful life (sometimes this is zero)
  • Expected Life – The number of years that the asset will be productive.

With this information, yearly depreciation is easy to calculate. Let's say Company B bought a metal press (a fixed asset) to expand its bugle production line. The cost of the machine is $50,000 and it is expected to last for 10 years. At the end of the 10 years it can be sold off for parts and scrap metal with a salvage value of $5000. What is the annual depreciation under the straight-line method? The calculation for fixed asset depreciation is easy! Start by subtracting the Salvage Value from the Cost (Cost – Salvage). This will tell you the depreciable base (the amount actually depreciated over the useful life of the machine). Next just divide this amount by the Expected Life. The total formula:

(Cost – Salvage Value) / Expected Life

In our example: ($50,000 - $5000) / 10, or $4500 a year.

Each year this amount will be expensed under the Depreciation Expense (single year) and Accumulated Depreciation Expense (total for all years so far) categories. At the end of the tenth year, the total depreciable base will be accounted for. Is this set in concrete? No. Companies often re-evaluate the Expected Life and Salvage Value of machines. Changes to these figures will raise or lower the annual depreciation and these base changes to depreciating assets are allowed.

Taxes and Accountability

Accounting for depreciation is also a fairly straightforward process. Again, it is important to know that the book value of an asset is not necessarily indicative of fair market value. Each year, the accumulated depreciation acts as a contra asset account to track the amount of an asset that is still on the books. The asset may eventually be sold for more or less than this value. This is why fixed asset depreciation is not a valuation method but an allocation method.

Because depreciating assets relies on estimates for Expected Life and Salvage Value, it can be manipulated by businesses to raise and lower net income. The accounting world and the IRS frown upon this practice. The IRS has established guidelines that limit the fixed asset depreciation that can be taken in a given year by a business for different types of assets. A business must reconcile its books to span the difference between what the business claims for depreciation and what the IRS will allow them to claim.

Understanding the rules of fixed asset depreciation are incredibly useful. Many businesses are performing cost segregation analysis to isolate things that can be expensed or depreciated more quickly than the unit as a whole. Cost segregation is allowed by the IRS and is generally performed by an audit team composed of both internal and external people. A cost segregation study might find, for instance, that certain parts of a building's interior can be depreciated at a faster rate than the building itself. This can save a company a large sum of money in a very short time.

Depreciating assets is a useful concept and ensures that a business is held accountable for its operations. Transparency and compliance are on the rise because of Sarbanes-Oxley. A business wants to do everything it can to present truthful information to potential investors, lenders, and customers. GAAP is a great place to start. It is also important to note that as International GAAP merges with U.S. GAAP, several changes will come to companies that rely on one method of depreciation over another. Not every type is allowed under each set of principles and fixed asset depreciation will definitely have to be re-investigated.

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