For
purposes of keeping the books for your small company, depreciation is
the method used to distribute the cost of a fixed asset over its useful
life. Depreciation expense is recognized in each period, in order to
match the income generated by the company with the expenses incurred in
order to produce the revenue, including part of the cost of property,
plant and equipment. An offset is recorded in accumulated depreciation,
which is an account with a credit balance in the asset section of the
balance sheet. Accumulated depreciation is presented in the financial
statements along with the corresponding assets, to show the balance in
property, plant, and equipment, net of depreciation. For tax
purposes, depreciation is the way you recover the cost represented by
your investment in the asset, through deductions you can take on your
annual federal income tax return.
Depreciation for financial
accounting purposes; that is, the depreciation you record on your books
and report in your financial statements, can be different from the
depreciation you can claim for tax purposes.
Depreciation Methods for Financial Accounting Purposes
Depreciation for financial accounting purposes can be calculated based
on production or the passage of time. When it is calculated based on
time, depreciation can be straight-line, with equal charges every
period, or it can be decreasing, with higher charges at the beginning of
the asset's useful life, that decrease over time.
Depreciation Based on Level of Activity or Units of Production
According to this method, the asset is depreciated based on its use or
productivity instead of the passage of time. The useful life of the
asset is defined based on its yield or capacity, such as the quantity of
units it can produce, or the hours it can work.
In order to use
this method, you need to know the capacity of the asset, such as a
machine, during its useful life. This information could be available in
the user's manual or in the technical specifications for the machine, or
you could make an estimate based on experience with the same or a
similar machine. You also need to keep records of the number of units
actually produced each period, or the number of hours the machine
operates.
The depreciation charge for the period, in the case of units of production, would be calculated as follows:
Cost of the asset less salvage value = depreciable amount.
Depreciable amount divided by total number of units that the asset
will produce during its useful life = depreciation charge per unit.
Depreciation charge per unit multiplied by the number of units
produced during the period = depreciation charge for the period.
Straight-Line Depreciation
According to the straight-line method, depreciation is calculated as a
function of time and not use. This method is based on the idea that the
wear on the asset and its obsolescence, and therefore the reduction of
its usefulness, occurs uniformly and progressively during the useful
life of the asset, so equal charges are made to depreciation every
period. This method is widely used in practice due to its simplicity.
In order to calculate straight-line depreciation, you need to know the
book value of the asset, its useful life and its residual or salvage
value. The book value would normally be the cost of the asset, including
all costs to put the asset in the place and condition in which it can
be operated for its intended purpose. The useful life will depend on the
type of asset; for example, a building could have a useful life of
about 50 years, while a computer could have a useful life of from 3 to 5
years. The salvage value could be the price at which you could sell the
asset when it is no longer useful in your operation. In many cases, the
salvage value is the scrap value in the case of machinery that is
completely worn out at the end of its useful life.
Straight-line depreciation is calculated as follows:
Book value of the asset - salvage value / useful life (in years or months) = depreciation charge per period (year or month).
Decreasing Depreciation
According to decreasing depreciation methods, charges for depreciation
are higher in the earlier years and lower in the later years. These
methods may be more appropriate when the asset loses more of its
capacity for service during the first part of its useful life. There are
different ways to calculate decreasing depreciation, such as the sum of
the years' digits, and the double declining balance methods.
Sum of the years' digits:
A decreasing fraction is applied to the depreciable value of the asset
(original cost less salvage value). The denominator of the fraction is
the sum of the digits that represent the years of life, and this
denominator remains constant. The numerator of the fraction decreases
from one year to the next. For example, for an asset with a useful life
of 5 years, the denominator of the fraction would be 15 (5 + 4 + 3 + 2 +
1 = 15). The first year, the factor to be applied to calculate the
depreciation would be 5/15, the second year 4/15 and continuing on
successively until in the fifth year it would be 1/15.
Double declining balance:
According to this method, a percentage is applied to the net book
value of the asset (cost less accumulated depreciation). The percentage
that is applied is double the percentage that would be applied under the
straight-line depreciation method.
For example, a machine that
has a cost of $10,000 and a useful life of 5 years, the depreciation
percentage according to the straight-line method would be 20% (1/5).
According to the double declining balance method, double that rate would
be applied, so at 40% the depreciation charge for the first year would
be $4,000 ($10,000 x 40%). The second year, the same 40% rate is applied
to the net value of $6,000, which is the original cost of $10,000 less
accumulated depreciation of $4,000, resulting in a depreciation charge
of $2,400 ($6,000 x 40%) the second year. This would continue on
successively until the asset if fully depreciated down to its salvage
value.
Depreciation for Tax Purposes
In
general, a taxpayer cannot take a deduction for the entire cost of an
asset used in a business in the year the asset is acquired if the asset
has a useful life of over one year. (An exception to this general rule
is the section 179 deduction.) Instead, the cost is recovered through
depreciation deductions over the useful life of the asset. The U.S.
Internal Revenue Service (IRS) establishes guidelines for determining
which assets are subject to depreciation or amortization, as well as the
methods that must be used to calculate depreciation.
Assets Subject To Tax Depreciation
In order to depreciate or amortize assets for tax purposes, the assets must satisfy the following tests:
The assets must belong to the taxpayer, although leasehold
improvements can also be depreciated when the improvements constitute
capital assets.
The assets must be used in a business or an
activity for the production of taxable income. It cannot be property
that is used exclusively for personal purposes. If an asset is used for
both business and personal activities, such as a vehicle or a portion of
your home used for business, you can take a depreciation deduction for
the proportional cost of the asset that corresponds to the percentage of
business use.
The assets must have a determinable useful life that is longer than one year.
It cannot be property specifically excluded according to the IRS, such
as land, goods placed in service and later sold or disposed of the same
year, and certain intangible assets such as franchises, non-competition
agreements, and goodwill.
How to Determine the Depreciation Deduction
In order to determine the depreciation you can deduct for tax purposes, you need to know the following:
When the asset was placed in service, which is generally the date on
which the asset was ready and available for use, regardless of whether
it actually started to be used on that date.
The basis of the
asset for tax purposes. The basis can be cost or some other amount,
depending on how you acquired the asset. For example, an asset that is
acquired in a taxable exchange is normally its fair market value on the
date of the exchange. You can consult chapter 13, Basis of Property, in
IRS Publication 17 (www.irs.gov) for more guidance on how to determine the basis of assets for tax purposes.
The applicable depreciation method. The majority of assets are
depreciated according to the Modified Accelerated Cost Recovery System
of the IRS. This method applies to assets placed in service after 1986.
But there are certain situations where you cannot use this method. IRS
Publication 946, How to Depreciate Property, indicates the situations
where you must use another method.
The asset life, according to
the classes established by the IRS. In Publication 946, there is a table
that shows the different types of assets and their corresponding
classes.
Section 179 Deduction
In some cases, a
taxpayer can elect to take a deduction for all or part of the cost of
certain items the first year, rather than recovering the cost through
depreciation. This special deduction, according to section 179 of the
Internal Revenue Code, applies only to assets acquired for use in a
trade or business. It does not apply to items occupied in other
income-producing activities, such as rentals, which do not constitute
the taxpayer's line of business. For more information on this deduction,
you can consult IRS Publication 946, as previously indicated.
Additional First-Year Depreciation
For certain qualified items, it may be possible to take a deduction
for additional depreciation the first year. This additional depreciation
is 30% for assets acquired after September 10, 2001, or 50% for assets
acquired after May 5, 2003.
Reconciliation of Depreciation for Book and Tax Purposes
As can be seen from the foregoing, depreciation for book purposes can
be different from depreciation for tax purposes. The necessary records
and documentation need to be kept in order to correctly calculate
depreciation in both cases, and these records must be maintained
throughout the life of the assets.
For tax purposes, in addition
to being able to take the corresponding depreciation deductions each
year, it will be necessary to know the amount of accumulated
depreciation in the event you sell or dispose of an asset, in order to
calculate the gain or loss on the sale or disposal, and to determine any
depreciation that may have to be recaptured as ordinary income for tax
purposes.
