Depreciation is a basic expense of doing business, reducing a company’s earnings while increasing its cash flow. It affects three key financial statements: balance sheet; cash flow; and income (or profit and loss). It is based on two key facts: the purchase price of the items or property in question, and their “useful life.”
Depreciation values and practices are governed by the tax laws of both national governments, and state or provincial governments, which must be monitored continuously for any changes that are made. Accounting bodies, too, have developed standard practices and procedures for conducting depreciation.
Depreciating a single asset is not difficult: The challenge lies in depreciating the many assets possessed by even small companies, and it is intensified by the impact that depreciation has on income and cash flow statements, and on income statements. It is essential to depreciate with care and to rely on experts, ensuring that they fully understand the current government rules and regulations.
What is depreciation?
It is an allocation of the cost of an asset over a period of time for accounting and tax purposes. Depreciation is charged against earnings, on the basis that the use of capital assets is a legitimate cost of doing business. Depreciation is also a noncash expense that is added into net income to determine cash flow in a given accounting period.
What is straight-line depreciation?
One of the two principal depreciation methods, it is based on the assumption that an asset loses an equal amount of its value each year of its useful life. Straight-line depreciation deducts an equal amount from a company’s earnings each year throughout the life of the asset.
What is accelerated depreciation?
The other principal method of depreciation is based on the assumption that an asset loses a larger amount of its value in the early years of its useful life. Also known as the “declining-balance” method, it is used by accountants to reduce a company’s tax bills as soon as possible, and is calculated on the basis of the same percentage rate each year of an asset’s useful life. Accelerated depreciation also better reflects the economic value of the asset being depreciated, which tends to become increasingly less efficient and more costly to maintain as it grows older.
What can be depreciated?
To qualify for depreciation, assets must:
be used in the business;
be items that wear out, become obsolete, or lose value over time from natural causes or circumstances;
have a useful life beyond a single tax year.
Examples include vehicles, machines and equipment, computers and office furnishings, and buildings, plus major additions or improvements to such assets. Some intangible assets can also be included under certain conditions.
What cannot be depreciated?
Land, personal assets, inventory, leased or rented property, and a company’s employees.
Making It Happen
In order to determine the annual depreciation cost of assets, it is necessary first to know the initial cost of those assets, how many years they will retain some value for the business, and what value, if any, they will have at the end of their useful life.
For example, a company buys a truck to carry materials and finished goods. The vehicle loses value as soon as it is purchased, and then loses more with each year it is in service, until the cost of repairs exceeds its overall value. Measuring the loss in the value of the truck is depreciation.
Straight-line depreciation is the most straightforward method, and is still quite common. It assumes that the net cost of an asset should be written off in equal amounts over its life. The formula used is:
(Original cost – Scrap value) ÷ Useful life
For example, if the truck cost $30,000 and can be expected to serve the business for 7 years, its original cost less its scrap value would be divided by its useful life:
(30,000 – 2,000) ÷ 7 = $4,000 per year
In theory, an asset should be depreciated over the actual number of years that it will be used, according to its actual drop in value each year. At the end of each year, all the depreciation claimed to date is subtracted from its cost in order to arrive at its “book value,” which would equal its market value. At the end of its useful business life, any undepreciated portion would represent the salvage value for which it could be sold or scrapped.
For tax purposes, some accountants prefer to use accelerated depreciation to record larger amounts of depreciation in the asset’s early years in order to reduce tax bills as soon as possible. In contrast to the straight-line method, the accelerated or declining balance method assumes that the asset depreciates more in its earlier years of use. The table overleaf compares the depreciation amounts that would be available, under these two methods, for a $1,000 asset that is expected to be used for five years and then sold for $100 in scrap.
|Straight-line Method||Declining-balance Method|
|Year||Annual Depreciation||Year-end Book Value||Annual Depreciation||Year-end Book Value|
|1||$900 × 20 per cent = $180||$1,000 – $180 = $820||$1,000 × 40 per cent = $400||$1,000 – $400 = $600|
|2||$900 × 20 per cent = $180||$820 – $180 = $640||$600 × 40 per cent = $240||$600 – $240 = $360|
|3||$900 × 20 per cent = $180||$640 – $180 = $460||$360 × 40 per cent = $144||$360 – $144 = $216|
|4||$900 × 20 per cent = $180||$460 – $180 = $280||$216 × 40 per cent = $86.40||$216 – $86.40 = $129.60|
|5||$900 × 20 per cent = $180||$280 – $180 = $100||$129.60 × 40 per cent = $51.84||$129.60 – $51.84 = $77.76|
While the straight-line method results in the same deduction each year, the declining-balance method produces larger deductions in the first years and far smaller deductions in the later years. One result of this system is that, if the equipment is expected to be sold for a higher value at some point in the middle of its life, the declining-balance method can produce a greater taxable gain in that year because the book value of the asset will be relatively lower.
The depreciation method to be used for a particular asset is fixed at the time that the asset is first placed in service. Whatever rules or tables are in effect for that year must be followed as long as the asset is owned.
Depreciation laws and regulations change frequently over the years as a result of government policy changes, so a company owning property over a long period may have to use several different depreciation methods.
Tricks of the Trade
With very specific exceptions, it is not possible to deduct in one year the entire cost of an asset if that asset has a useful life substantially beyond the tax year.
To qualify for depreciation, an asset must be put into service. Simply purchasing it is not enough. There are rules that govern how much depreciation can be claimed on items put into service after a year has begun.
It is common knowledge that if a company claims more depreciation than it is entitled to, it is liable for stiff penalties in a tax audit, just as failure to allow for depreciation causes an overestimation of income. What is not commonly known is that if a company does not claim all the depreciation deductions it is entitled to, it will be considered as having claimed them when taxable gains or losses are eventually calculated on the sale or disposal of the asset in question.
While leased property cannot be depreciated, the cost of making permanent improvements to leased property can be (remodeling a leased office, for example). There are many rules governing leased assets; they should be depreciated with care.
Another common mistake is to continue depreciating property beyond the end of its recovery period. Cars are common examples of this.
Conservative companies depreciate many assets as quickly as possible, despite the fact that this practice reduces reported net income. Knowledgeable investors watch carefully for such practices.