Depreciation literally means the lowering of the value of something—and specifically of fixed or capital assets.
In accounting terminology the word refers to an entry on the balance sheet which records the amount of money deducted from total assets because the assets have aged.
All capital assets are subject to depreciation except land.
The current year’s depreciation of capital assets may be deducted from income for tax purposes. A business purchasing a van for deliveries must put the acquisition cost of the van, say $36,000, on its books as a capital asset.
Tax law permits depreciation of the van over five years.
Using a straight-line method of depreciation, the annual depreciation of the van would be $7,200. In actuality the small business may handle depreciation in another way under current tax law, to be discussed below, but this example illustrates the concept. The annual depreciation of $7,200 is treated as a cost, deductible from profits, and therefore it reduces income taxes.
The traditional treatment of capital assets—their depreciation over a number of years—is based on the simple fact that buildings, machinery, vehicles, roads, and other improvements of this type have a life of multiple years. In theory they are paid for from savings accumulated over multiple years and are depreciated (written off) over their useful life. Land is not depreciated because it never wears out. Bookkeeping is aimed at accurately reflecting on-going operations—in the current year. For this reason capital inflows are not reflected in income and depreciation is spread out over the life of the asset.
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The Balance Sheet Perspective
Company balance sheets are divided into Assets and Liabilities. On the Asset side, the ledger shows current and fixed assets. Fixed Assets are subdivided into such categories as Vehicles, Furniture and Fixtures, Equipment, and Buildings. As such assets are acquired, their actual costs of acquisition are entered under these categories. Each of these categories, however, is followed by a line which says: “Less: Accumulated Depreciation.” Each year a portion of the asset is added to the depreciation line. The net of these two values (acquisition costs less accumulated depreciation) is what is counted as “fixed assets.” The role of depreciation in the accounting sense, therefore, is to keep the books honest: only the actualremaining value of fixed assets is counted on the books.
Accountants calculate how much of each category of assets to depreciate every year by using Generally Accepted Accounting Principles (GAAP) established by Financial Accounting Standards Board. Within a single category, such as buildings, for instance, the life of a structure may vary from 10 years for a tool shed to 80 years for fireresistant bearing walls, beams, decks, and floors. The acquisition cost is divided by the appropriate number of years. Very complex schedules are used to determine “life.”
The Tax Perspective
Depreciation is treated as a cost category in tax calculations. It is not a “cash cost” because no actual disbursement of cash takes place; depreciation is simply an entry in the books. But for tax purposes depreciation has a “cash consequence”: it reduces the actual tax liability of a company. From a tax perspective, therefore, any law that permits higher deductions of depreciation than accounting principles specify are favorable for the corporation: no cash payment is involved in so-called “accelerated depreciation” but real cash benefits result: lower taxes.
Letting companies speed up depreciation has, for this reason, become a popular technique of lowering taxes and thus, by giving more money to companies, stimulating the economy. Regulating depreciation in the tax code is also a relatively precise instrument. Congress can aim its policy at certain categories of expenditures. It can, for instance, stimulate purchases of vehicles by letting businesses write them off more quickly; or it can favor a broad category such as computers. Congress has done both. It could also, at its discretion, stimulate industrial construction, for instance, by letting companies write off buildings or land improvements quickly.
In the example presented at the beginning, for instance—the $36,000 van—under the rules in force during the 2004 tax year, a small business could write off a substantial portion of that van ($24,000) in the year of acquisition, the remainder over five years. In these situations a maximum cap usually applies. In 2004 tax years, for example, the cap was $102,000.
Cash Flow Calculation
Businesses calculate the cash flow of their business— usually in the context of justifying loans. Cash flow is simply the netting out, for a given period (a quarter, a year, multiple years) of all cash coming in from sales and cash flowing out for purchases and payments on debt and interest. In this context, however, depreciation is often mentioned as part of the cash flow calculation: depreciation is said to be “added back.” The phrasing produces confusion. Cash flow calculations are often automated so that all current income and current costs are cumulated; costs are then deducted from income to derive the cash flow. But in this process some costs are not cash costs.
Depreciation is one of those. Therefore, to get an accurate cash flow, depreciation must be added back in because it was not a cash cost in the first place.
Alternative Methods Used
Depreciation may be calculated in a variety of ways all of which are specified in law and elaborated in the Generally Accepted Accounting Principles. Major categories are 1) the straight-line method, 2) units-of-production method, 3) declining-balance method, and 4) sum-of-the-years-digits method.
Straight-Line The residual (salvage) value of the asset is first estimated. Thereafter the asset, minus salvage value, is divided by the useful life of the asset. The resulting value is deducted for each year of the asset’s life.
Units-of-Production This method is used when the usage of the asset varies from year to year and its use can be determined by some measure such as miles driven, tonnage hauled, cuts made, etc. Again, salvage value is deducted. Next, the remaining value is divided by the total units the asset is estimated to be able to produce.
Units produced are recorded for every year. Depreciation for each year is calculated based on the units. Thus depreciation may be very high one year, low in another year—until the total count of units has been used up.
Declining-Balance This method, also known as doubledeclining-balance, is an accelerated method of depreciation because depreciation is highest in the first year and then declines with each year. The formula requires dividing 2 by the years of life to get a percentage and then applying that percentage to the balance of the asset.
Assuming a three-year life for a $5,000 asset, the first year of depreciation will be 5,000 x (2/3) = $3,333. The asset is then reduced by that amount and becomes $1,667. The second year, the depreciation is 1,667 x (2/3) or .66667 = $1,111. Again, the asset is reduced by that amount, leaving $556. The procedure is repeated again. Under this method, however, the asset may not be depreciated below its salvage value; for this reason, the third year operation may not be possible.
Sum-of-the-Years-Digits Supposing that the life of an asset is five years. In that case the sum of the year’s digits will be 1+2+3+4+5 = 15. The asset value less its salvage value is calculated. Let us assume that the result is $8,750. In the first year the net asset value will be multiplied by the fraction 5/15 (0.333), in the second by 4/15 (0.2667), in the third by 3/15 (0.2), and so on, yielding depreciations streams of $2,914, $2,333, $1,750, and son on. After five years, the total depreciation streams will sum to $8,750.
It is worthwhile to know about such fascinating things as sum-of-the-years-digits, but most small business owners have better things to do. Those with substantial fixed assets typically seek the advise of a certified public accountant (CPA) and profit by his or her professional experience. In the mid-2000s, when government appeared intent on cutting taxes first and then asking questions later—and the environment was favorable to small business, seen as the only generator of new jobs— substantial tax savings and incentives to invest were available in an ever changing tax code to which the CPA was an invaluable guide.