Depreciation / Depreciation schedule

Encyclopedia of Business Terms and Methods, ISBN 978-1-929500-10-9. Copyright 2012 by Marty J.Schmidt. Revised 11 January 2012.

The Meaning of Depreciation, Depreciation Schedule, and Related Terms

Depreciation expense is an accounting and financial reporting practice, used primarily by businesses that pay tax on income. On the income statement, depreciation expense appears as a charge against income, that is, it is subtracted from sales revenues to produce a lower reported income (lower profit, lower earnings). Depreciation provides a way to account for the purchase of long-lasting assets over a period of years. The idea is that assets have a useful life (depreciable life), over which they are used up or worn out, and that the owner receives the tax benefits of paying for the asset over those years instead of all at once. Depreciation is more fully explained and better understood in the context of several depreciationrelated terms including the following Accelerated depreciation Depreciable cost Depreciable life Depreciation schedule Double declining balance schedule (DDB) Salvage value Modified accelerated cost recovery system schedule (MACRS) Residual value Straight line method (SL) Sum of the years' digits schedule (SOYD)

Depreciation Example: Depreciation Lowers Reported Income

Each year in the life of a depreciable asset, some of its cost is charged against income on the income statement. Just how much is charged each year is determined by the depreciation schedule (see Depreciation Schedules, below). In the example income statement below, Grande Corporation pays an income tax of $957,950 on an income (before extraordinary items) of $2,737,000 (the reported tax is rounded up to $958 thousand on the statement). Contributing to expenses, however, are three depreciation items totaling $659,000. Had depreciation been omitted from this statement, Grande Corporation would have had a before-tax operating income of $3,396,000 and an income tax of $1,188,860. Grande Corporation Income Statement for Year Ending 31 December 2012

Figures in 1,000s Gross sales revenues.................33,329 Less returns & allowances.......... 346 Net sales revenues...........................32,983 Cost of goods sold Direct materials................... 6,320 Direct labor....................... 6,100 Manufacturing overhead Indirect labor........... 5,263 Depreciation, mfr equip... 360 Other mfr overhead....... 4,000 Net mfr overhead................. 9,623 Net cost of goods sold...................22,043 Gross profit.................................10,940 Operating expenses Selling expenses Sales salaries........... 4,200 Warranty expenses........ 730 Depreciation, store equip 120 Other selling expenses... 972 Total selling expenses........... 6,022 General & admin expenses Administration salaries.. 1,229 Rent expenses............ 180 Depreciation, computers.. 179 Other gen & admin exp.... 200 Total gen & admin exp............ 1,788 Total operating expenses.............. Operating income before taxes............... Financial revenue & expenses Revenue from investments............ 118 Less interest expense............... 511 Net financial gain (expense)............ Income before tax & extraordinary items..... Less income tax on operations............. Income before extraordinary items........... Extraordinary items Sale of land................. Less initial cost............ 610 145

7,810 3,130

(393) 2,737 958 1,779

Net gain on sale of land.......... 465 Less income tax on gain ............ 118 Extraordinary items after tax............

347

Net Income (Profit).......................... 2,126 Using rounded figures from the staement, the tax savings from depreciation is thus $230,000 i.e., $1,188,000 $958,000 = $230,000. This tax savings can also be estimated directly as the product of depreciation expense and the tax rate. With a tax rate on income of 35%, for example, 0.35*$659,000 = $230,650. Notice also that depreciation expense can appear in any of the main expense categories, depending on how the asset in question is used. Here depreciation expense appears under Cost of goods sold, as Manufacturing overhead (depreciation of manufacturing equipment), under Selling expenses (depreciation of store equipment), and under General and administrative expenses (depreciation of computers).

What Can Be Depreciated?

Generally, depreciation can be claimed for assets that (a) have a useful life of one year or more, (b) are used in a trade or business, and (c) which are used up, wear out, decay, become obsolete, or otherwise lose value over their useful life. Assets that meet these criteria may include factory machines, vehicles, computer systems, office furniture, aircraft, and buildings. Land, however, is an example of an asset that does not meet the third criterion (losing value), and therefore cannot be depreciated in the same way. The country's tax laws sometimes give the accountants and financial officers some choice in deciding whether or not to classify some acquisitions as assets (and therefore eligible for claiming depreciation expense), although the freedom of choice is limited. In 2005, for example, several senior executives of Worldcom in the United States were convicted of fraudulent reporting for having overstepped the boundaries, for classifying services paid for by the company as assets rather than as expenses, as they should have been.

Cash Flow vs. Depreciation Expense

Depreciation expense is an accounting convention, not real cash flow. When a company buys an asset outright with cash, all the cash flows at once in the purchase transaction (this shows up on the company's cash flow statement under "Uses of Cash"). On the income statement, however,

the expense is spread across the years of the asset's depreciable life. Depreciation expense thus lowers reported income across several years or more. Although depreciation expense is not real cash flow itself, it does bring a cash flow consequence each year of the depreciable life. Because depreciation expense lowers reported income, it brings a tax savings that is a real cash flow.

Depreciable Life, Depreciable Cost, and Residual Value

The depreciation expense claimed for an asset each year normally depends on four factors: The asset's depreciable life The asset's initial cost The asset's residual value The depreciation schedule used for the asset's depreciable life (the time period over which an asset can lawfully be depreciated). For some assets, management can simply choose a number of years for the depreciable life, based on the the asset's expected useful life. For some kinds of assets, however, the depreciable life is prescribed by the country's tax authorities. In the US, for instance, computing hardware has a prescribed depreciable life of 5 years, and depreciation must follow the MACRS (Modified Accelerated Cost Recovery System) depreciation schedule. An asset's depreciable life can be different from its economic life. The term economic life refers to actual period of usefulness of an asset, the period beyond which it is cheaper to replace or scrap an asset than to continue maintaining it. Economic life and depreciable life are both central concepts in the practice of asset life cycle management. An asset is originally valued on the balance sheet at its actual original cost (this is the historical cost convention in accounting). For depreciation purposes, the original cost may include two components: Original Cost of Asset = Depreciable Cost + Residual Value Only the depreciable cost component will be claimed as depreciation expense across the years of depreciable life. The asset's residual value (sometimes called salvage value) remains at the end of depreciable life. Residual value is the estimated net value of the asset that would or could be received if the asset were retired or scrapped.

The figure at left shows how an asset originally costing $100 decreases in book value to its residual value over its depreciable life, as depreciation expense is charged each year (the example shows straight line depreciation across a 5 year life). Most depreciation schedules are applied to the depreciable cost rather than total cost, but the double declining balance method (DDB) is an exception, as is MACRS, a special case of DDB (see Depreciation Schedules, below, for more on these methods). For DDB and MACRS, depreciation percentages are applied against total original cost. When using any schedule besides DDB and MACRS, residual value plays an important role in determining depreciation expenses, tax savings from depreciation and, possibly, the value of a cash inflow at the end of depreciation. Residual (or salvage) value of an asset has two important tax considerations:

An asset may NOT normally be depreciated below its estimated residual (salvage) value. If, at the end of depreciable life, the realized salvage value of an asset differs from the book value, a tax adjustment will usually be required.

Depreciation Schedules
The length of an asset's depreciable life and the amount of depreciation a company can claim for it each year, are given by depreciation schedules. Tax laws in each country specify which depreciation schedules can be used for various classes of assets, although in some cases the company has a limited range of schedule choices.

Straight Line Depreciation Schedule (SL)

The simplest schedule, so-called straight line depreciation spreads depreciation expenses evenly across an assets depreciable life: A $100 asset fully depreciated over 5 years (and having no residual value) would allow the owner to claim $20 depreciation expense each year for five years.

Other time-based depreciation schedules described below are called accelerated depreciation schedules because they "accelerate" depreciation. Three other time-based schedules below charge relatively more in early years, and relatively less in later years. Accelerated schedules thus enable a company to claim relatively more of an asset's depreciation-related tax savings in the early part of the asset's depreciable life.

Modified Accelerated Cost Recovery System Schedule (MACRS)

Many US companies use the 1986 modification of the 1981 Accelerated Cost Recovery System (ACRS) for certain classes of assets, known as the Modified Accelerated Cost Recovery System, or MACRS. MACRS is thus only for US use. MACRS specifies different schedules for calculating depreciation expense for several kinds of assets: Computing equipment falls into the "5-year class" of property, along with most other office equipment and automobiles. MACRS thus prescribes a 60 month depreciable life for computers, spread across 6 fiscal years (the 60 month period is usually started at the midpoint of year 1). There are several variations and options on MACRS schedules but the primary usage is to apply the double declining balance (DDB) method (see below), using a mid year-1 start. Residual value (salvage value) is ignored. MACRS (along with DDB and SOYD methods, below), is a form of accelerated depreciation, in which relatively more depreciation expense is claimed early in the depreciable life, and relative less is claimed later in the life. MACRS rules in fact provide two possible depreciation schedules for different asset classes: a General Depreciation Schedule (GDS) which is most frequently used, and an Alternative Depreciation Schedule (ADS) which may be used in some cases. A few of the GDS and ADS schedules Include: Office Furniture: GDS 7 Years, ADS 10 Years Computers: GDS 5 Years, ADS 6 Years Construction Assets: GDS 5 Years, ADS 6 Years Railroad cars & Locomotives: GDS 7 Years, ADS 15 Years The full set of MACRS schedules and rules for various asset classes are given in US Government IRS Publication 946, "How to Depreciate Property."

Double Declining Balance Schedule (DDB)

The double declining balance schedule (DDB) is a form of accelerated depreciation that prescribes twice an annual rate of the straight line method. Under the DDB method, twice the straight line rate is applied each year to the remaining non depreciated value of the asset.

Sum-of-the-years'-digits (SOYD)
The sum-of-the-years'-digits schedule (SOYD) is an accelerated method of depreciation based on an inverted scale of total digits for the years of depreciable life. For five years of life, for example, the digits 1,2,3,4 and 5 are added to produce 15. The first years rate becomes 5/15 of

the depreciable cost (33.3%), the second years rate is 4/15 of depreciable cost (26.7%), the third years rate 3/15, and so on. The table below compares depreciation percentages applied each year against the depreciable cost of an asset having a 5-year depreciable life. Figure in the table show % depreciated per year. These depreciation schedules are shown graphically below the table. Schedule Straight Line MACRS Dbl Decl Bal Sum of Yrs Digits Year 1 20.00 20.00 40.00 33.33 Year 2 20.00 32.00 24.00 26.67 Year 3 20.00 19.20 14.40 20.00 Year 4 20.00 11.52 8.64 13.33 Year 5 20.00 11.52 5.18 6.67 Year 6 5.76

Note that MACRS here refers to a 5-year depreciable life, but which is spread across 6 fiscal years, beginning at the midpoint of year 1.

Non Time-Based Schedules

All of the schedules above are time based schedules because they treat depreciable life as a fixed period of time, charging a given percentage of depreciable cost each year as depreciation

expense. Note, however, that sometimes, so called Usage-Based Depreciation is permitted. A vehicle under this plan, for instance, might have its depreciable life defined not in years, but in terms of total miles or kilometers driving expected during its life. The depreciation expense each year would reflect the distance traveled that year as a percentage of the lifetime total. Similarly, other kinds of assets might have depreciable life defined as quantity that will be used up, in which case depreciation percentage each year is based on the quantity used up.

Composite Depreciation
Composite depreciation is a method of depreciation in which a group of related assets is depreciated as a whole rather than individually. This can reduce unnecessary record keeping and reporting and might be used, for example, in depreciating a companys office furniture, or office equipment. See the encyclopedia entry composite depreciation for an explanation and example.

Depreciation Expense: Spreadsheet Implementation

The depreciation expense for one asset, each year, is found simply by multiplying its depreciable cost by a given percentage for that year, Calculating total depreciation expenses can be challenging, however, when the total involves multiple assets and multiple schedules across several years or more. Consider, for instance building a spreadsheet summary of total depreciation expenses for each of five years, with the following assets and schedules involved: Asset A, 4 year life, SL schedule, acquired Year 1. Asset B, 5 year life, MACRS schedule, acquired Year 2. Asset C, 8 year life, DDB schedule, acquired Year 3. Asset D,10 year life, SL schedule, acquired Year 4.

Calculating total depreciation expense becomes more complicated with each passing year: Year 1 Total depreciation expense: = (Asset A depreciable cost ) * ( SL % for Year 1 of 4 ) Year 2 Total depreciation expense: = (Asset A depreciable cost ) * ( SL % for Year 2 of 4 ) + (Asset B depreciable cost ) * (MACRS % for Year 1 of 6 ) By Year 4, Total depreciation expense: = ( Asset A depreciable cost ) * ( SL % for Year 4 of 4 ) + ( Asset B depreciable. cost ) * ( MACRS % for Year 3 of 6 ) + ( Asset C depreciable cost ) * ( DDB % for Year 2 of 8 ) + ( Asset D depreciable cost ) * ( SL % for Year 1 of 10 )

The principles involved in these calculations are simple but the bookkeeping task for the spreadsheet analyst becomes tedious and cumbersome, especially as the number of years considered increases. (You can see and try out working examples of depreciation calculations across multiple years, in either Financial Metrics Pro or Financial Modeling Pro.)

Basic Accounting Rules for Depreciation

Written by: Jean Scheid Edited by: Ronda Roberts Updated May 21, 2011 Related Guides: Internal Revenue Service Confused about depreciation on fixed assets? Depreciation is simply the calculation of wear and tear on assets and is reported annually on your financial statements and utilized as a business expense when submitting tax returns. Learn the most common methods used here.

About This Business Expense

Depreciation is the reduction in the book value of an asset due to usage over a period of time. In other words, it is the reduction in the economic usefulness of the asset, or the calculation of wear and tear that may have occurred to the asset. This is also done to report the actual value to tax authorities. The present value of the asset, i.e., after deducting the depreciation amount, is then recorded in the accounting books. To calculate, one needs to take into account the economic life and the expected value or scrap value of the asset after its use in the business is over. The calculation is a non-cash expense that is estimated or forecasted. This process occurs at the end of the financial year and the amount is shown in both the balance sheet and the income and loss statement. Here we discuss the different types of depreciation methods and how to calculate them.

Straight Line Method

This is the simplest, and most commonly used, form of depreciation calculation and refers to reduction of the value as per a constant rate. The depreciation value is calculated by taking the original, purchase, or historical price, less the scrap (or salvage) value, and dividing it by the useful years or the number of years that the asset would be in use in the business. The rate of depreciation remains constant as a fixed expense throughout the years. This depreciation method is useful for those assets in which the usage remains uniform or consistent. Unfortunately, it does not take into account the fact that all assets do not deteriorate equally. An example would be an alignment machine purchased for a body shop for $100,000. The straight line calculation is as follows: Cost of Alignment Machine - $100,000 Less Salvage Costs ($10,000) Subtotal - $90,000 Years of Useful Life 5 5 Years of Useful Life Divided by $90,000 = $18,000 So, for the first year, the alignment machine depreciation using the straight line method is $18,000 and the value on the accounting books at year end is $100,000 (purchase price) minus the depreciation ($18,000) = $82,000. The straight line depreciation method continues until the useful life (5 years) of the alignment machine has been reached as seen in the screenshot below (click to enlarge).

Reducing Balance Method

The reducing balance method allows you to consider a certain depreciation percentage to depreciate the alignment machine rate annually. This method takes into consideration an accelerated rate of depreciation. This is useful for those assets in which a higher value is lost during the beginning years of usage. The only flaw of this method is it does not take into account the scrap or residual value of the asset. In addition, most tax professionals will tell you the reducing balance method should be used for fixed assets where useful life is only three years and upon the fourth year, the straight line depreciation method should be implemented (check with

your tax professional to be sure). Below is an example of the declining balance method based on five years for our same alignment machine using 37 percent each year.

MACRS Method
The Modified Accelerated Cost Recovery System (MACRS) is widely used in the depreciation of land, buildings or equipment owned and used 100 percent by the company. MACRS is almost always utilized when depreciating assets for tax purposes to enjoy the expense of each depreciated item. In the Bright Hub article, MARCS Depreciation Formula: Explanation and Examples, you'll find great tips on how to use this method to help your business reap the tax benefits offered by this type of depreciation method. The Internal Revenue Service offers Form 4562 along with detailed instructions on the best way to utilize the MACRS method. You can download the form and instructions here. It you're unsure on how to best utilize the MACRS method, ask your tax professional for help.

Unit of Production Method

This method refers to an association between the assets ability to do work during its useful life and the decline in the worth of the asset. Unfortunately, this depreciation method does not take into account the expected years of the asset but takes into account the measurable units of use. The units could be anything, including number of items produced or hours used for machinery, number of miles traveled by vehicles, etc. Thus, it is calculated by the actual usage of the asset. Again using our alignment machine and assuming the machine can do 15 alignments in one year (365 days): Depreciation cost equals original purchase price less salvage value. ($100,000 - $10,000 = $90,000). Deprecation per item/unit equals depreciable costs divided by the number of total items or units. ($90,000 / 5,475 units - 16.44%). Depreciation - $90,000 * 16.44% = $14,796 per year.