Assessing Depreciation
Depreciation is a calculation used to work out the value of assets over time and use. It's drawn from two essential pieces of information—how much an asset originally cost, and its "useful life." Depreciation is a fundamental business expense, which increases cash flow at the same time as reducing income. Its effects can be seen on cash flow statements and profit and loss accounts, and on the balance sheet.
There are standards and procedures determining how depreciation is calculated, arising from national and state tax laws, and from accounting practice. These are sometimes subject to alteration, and should be checked regularly for any changes.
It's a straightforward matter to depreciate a single asset. However, depreciating the assets of an entire company (even a small one) is much more complex because of its effect on tax returns and financial statements. A thorough approach and expert support is essential, together with a good grasp of current conventions and legal parameters.
In relation to tax and accounting, depreciation is the process of allocating value to an asset over time. It is charged against earnings, starting from the premise that utilizing capital assets can justifiably be seen as a business cost. It's also added to net income as a non-cash expense, as part of defining cash flow during a particular accounting period.
There are two main methods of depreciating an asset: straight-line and accelerated (or declining-balance) depreciation. Straight-line assumes that an asset loses value at the same rate throughout its useful life, so an equal sum is deducted from earnings each year. Accelerated depreciation is more complex. It assumes that the value of an asset goes down most rapidly at the start of its useful life. Accountants employ this method to cut the amount of tax a company pays as quickly as possible, calculating the reduction as an annual percentage. This method is also a more accurate reflection of an asset's cost-effectiveness, since it's likely to become more inefficient and expensive to maintain as time passes.
Assets must pass a few "tests" to be eligible for depreciation. They must be used in the business, and either wear out with use, lose value over time or become obsolete. They must also have a useful life of more than one year. Examples of assets that can be depreciated are: machinery, equipment, furniture, buildings, vehicles and major upgrades/improvements to assets. Certain intangible assets might be eligible too, such as patents or trademarks. Others, like goodwill or particular brands, are deemed to have an infinite useful life, so are not eligible. Depreciation of intangible assets is also known as amortization. Assets that cannot be depreciated include land, stock, rented premises, personal assets (like life insurance policies or pension plans), and staff.
To work out depreciation, a company needs to know:
- the original cost of an asset;
- its useful life;
- any value it might retain at the end of that useful life.
For example, a company invests in some machinery which costs $10,000. It is expected to give five years' service before repair and maintenance costs outweigh the benefits of keeping it. The machine will then be scrapped and replaced. Scrap value is expected to be about $1,000.
Using the straightforward straight-line method, loss in value is measured by writing off equal amounts each year, according to the following formula:
Assuming a scrap value of $1,000, the calculation looks like this:
At each year-end, the book value of each asset is also calculated, which is equal to cost minus total depreciation to date. This is effectively the market value of the asset. Any remaining amount left undepreciated at the end of the asset's useful life is the actual salvage or scrap value. If book value and scrap value are different, any resultant income is taxed as a capital gain; likewise, any capital loss is tax deductible.
If the accelerated method of depreciation is used (the usual reason being to reduce tax bills as soon as possible), the sums work out slightly differently. The tables below compare the two methods, using the same example of an asset worth $10,000 over a period of five years:
| Annual Depreciation | Year-end Book Value | |
| Year 1 | 9,000 × 20% = $1,800 | 10,000 – 1,800 = $8,200 |
| Year 2 | 9,000 × 20% = $1,800 | 8,200 – 1,800 = $6,400 |
| Year 3 | 9,000 × 20% = $1,800 | 6,400 – 1,800 = $4,600 |
| Year 4 | 9,000 × 20% = $1,800 | 4,600 – 1,800 = $2,800 |
| Year 5 | 9,000 × 20% = $1,800 | 2,800 – 1,800 = $1,000 |
| Annual Depreciation | Year-end Book Value | |
| Year 1 | 10,000 × 40% = $4,000 | 10,000 – 4,000 = $6,000 |
| Year 2 | 6,000 × 40% = $2,400 | 6,000 – 2,400 = $3,600 |
| Year 3 | 3,600 × 40% = $1,440 | 3,600 – 1,440 = $2,160 |
| Year 4 | 2,160 × 40% = $864 | 2,160 – 864 = $1,296 |
| Year 5 | 1,296 × 40% = $518.40 | 1,296 – 518.40 = $777.60 |
Under the accelerated method, the book value is lower in the early years. This means that if the asset has to be sold off before the end of its predicted useful life, it will result in a higher taxable gain than if the straight-line method is used.
The method of depreciation—with accompanying rules and regulations—is fixed at the time the asset is first put into use, and followed for as long as the company owns the asset.
However, a different asset put into service later may be subject to different rules, because policy changes result in frequent amendments and revisions to depreciation laws and regulations.
- Assets must be depreciated over the whole of their useful life.
- It is not enough to buy an asset—in order to depreciate it, the asset must be used.
- If an asset is put into service after the start of the tax year, there are rules to determine the amount of depreciation that can be claimed.
- Companies over-claiming depreciation than are likely to be penalized. Similarly, companies omitting to allow for depreciation end up overstating their income.
- Companies may not be aware that for tax purposes, assets will be treated as if all their depreciation entitlements have been claimed—whether or not that is the case—when they come to the end of their useful life.
- It's worth noting that a company can claim depreciation on permanent improvements made to leased property, even though the cost of the lease itself cannot be depreciated. The rules around leased assets are complex and need careful study.
- Property may not be depreciated beyond the end of its recovery period.
- Investors should bear in mind that cautious companies which depreciate assets as quickly as possible will show a reduced net income.
Business Owner's Toolkit: www.toolkit.cch.com
Encyclopedia.com: www.encyclopedia.com
Bankrate.com: www.bankrate.com