Depreciation is the method that the company use for spreading the cost of an asset over its useful life. The cost is spread over several years because an asset loses fair value in the market over time. For tangible assets the term is used depreciation, for intangibles, it is called amortization.
Accounting depreciation or book depreciation is the method of recording depreciation entries for a tangible asset. It is recorded in the company’s books as a non-cash entry. There are different methods to record accounting depreciation.
Let us understand the concept of accounting depreciation and see how companies can use it to spread the cost of assets of their useful life.
What is Accounting Depreciation?
Accounting depreciation is the process of allocating the cost of a tangible asset over its useful life. The cost of an asset is spread over several years and a proportion of it is recorded in the books yearly.
The accounting depreciation method follows the matching principle of accounting. It is recorded in accordance with US GAAP or IFRS rules. The reporting company has the choice of following the accounting rules/standards as well as choosing the depreciation method.
Depreciation is used to record the current carrying value of an asset. It represents the fair value of an asset. An asset loses fair value in the market over time; hence, depreciation also represents the carrying value of an asset at any given time.
Recording Accounting Depreciation in Books
Depreciation is a non-cash item on the financial statements of a company. When depreciation is recorded, a company does not actually make a cash outflow. Despite that, it affects the cash flow and profits of a company.
Companies can select any depreciation method to allocate the cost of an asset proportionally. The monthly and yearly expense of depreciation is recorded on the income statement. The accumulated depreciation is recorded on the balance sheet of the company.
Let’s assume a company ABC purchased manufacturing equipment of $ 200,000. The company assumes its useful life to be 10 years. Further, the company uses a simple straight-line depreciation method. For simplicity, let’s assume the salvage value of the equipment will be zero after ten years.
|01-08-2015||Manufacturing Equipment||$ 200,000|
|31-12-2015||Depreciation Expense||$ 20,000|
|31-12-2016||Depreciation Expense||$ 20,000|
The company will continue to record the depreciation expense in the income statement for the next 10 years. However, as it has already made the purchase, it doesn’t have to make these yearly cash outflows again.
How Accounting Depreciation Affects Cash Flow?
Depreciation can have an impact on the cash flow of a company. It is a non-cash item. Hence, a company must adjust the cash flow statement for all depreciation and amortization entries for the financial year.
Continuing with our example above, the company will add back the yearly depreciation amount of $ 20,000 to the cash flow statement under the operating activities section. However, the initial investment will reflect the cash outflow in the investing activity section of the cash flow statement.
This is one reason why many analysts use earnings before tax, interest, depreciation, and amortization (EBTIDA) figures for their financial analysis.
Depreciation Impact on Profit
Depreciation cannot ultimately change the profitability of a company. As the company would already account for the initial investment as a cash outflow. However, depreciation spreads the costs of an asset.
It means the tax payable each year for the company changes with depreciation. If a company only records an initial expense, it will carry over large net losses for several years. It can impact the company’s solvency.
A company can use the depreciation methods to spread the cost of an asset. It will reduce the profits evenly and taxes payables each year as well.
How Accounting Depreciation is Different from Tax Depreciation?
Many companies use two different depreciation records at the same time. Accounting depreciation records for keeping the record books straight and tax depreciation for recording the tax entries.
The tax depreciation method follows rules set by the tax authorities in different jurisdictions. For instance, the IRS provides compliance guides on allocating depreciation costs of assets.
In tax depreciation, a company cannot depreciate every asset. The tax regulatory authorities set the threshold for assets that can be depreciated. Also, every asset can be depreciated for tax purposes for specified useful life spans.
Tax authorities provide guidelines on the useful life and depreciation methods for taxpayers. Companies can then classify different assets under the allowed categories and use depreciation methods to record depreciation as tax-deductible expenses.
Different Methods of Depreciation
There are several depreciation methods. A company can use straight-line or accelerated depreciation methods. The choice of accounting depreciation method can change the profits and hence tax payable each year.
Note: All depreciation methods can spread the cost of an asset up to its purchase value only. Thus, eventually, the choice does not make an effect.
Straight Line Method
It is the most common and simple method of recording depreciation. It spreads the cost of an asset evenly through the useful life.
A company can use the straight-line depreciation method to evenly spread out the cost of an asset. Thus, this method will bring consistent tax benefits to the company as well.
For example, a company buys equipment for $ 100,000. It estimates the residual value of the equipment at $ 20,000 after 8 years. The straight-line method will calculate the depreciation as:
Depreciation = (100,000 – 20,000)/8= $ 10,000 per year.
Declining Balance Method
The declining balance method uses the percentage amount of depreciation each year rather than an equal amount. It is used as an accelerated depreciation method by companies wanting to reduce tax liability aggressively.
The company sets a percentage amount for depreciation costs rather than the useful life years of an asset. In our example above, the company can decide to allocate 15% depreciation cost.
The depreciation cost with a declining method will be:
Depreciation Cost = (100,000-20,000) * 15% = $ 12,000
For Second year,
Depreciation Cost = (80,000 – 12,000) * 15% = $ 10,200, and so on until the asset reaches its residual value.
Double-Declining Balance Method
The double-declining balance method is another accelerated depreciation method used by companies to reduce their tax liability.
In this method, the company estimates the useful life of an asset. Instead of taking the exact percentage, it doubles the reciprocal percentage to accelerate the depreciation cost.
In our example above, if the company estimates the useful life of an asset to be 10 years, then (1/10=10%) it will use the double of the reciprocal. The double-declining method in this case will use a 20% depreciation cost for every year.
Sum of the Year Method
This method uses the combined sum of digits of the useful life of an asset. For instance, if the useful life of an asset is 5 years, the sum of the digits will be (1+2+3+4+5=15).
The depreciation cost will be allocated as:
Depreciation cost = 5/15 * Depreciable cost for the first year,
Depreciation cost = 4/15 * Depreciable cost for the second year, and so on.
Accounting depreciation is an accounting method to spread the cost of an asset over its useful life. It helps a company minimize tax liability.
It also adjusts the cash flow and operating profits on the financial statements of the company. A company can use one of several depreciation methods available to allocate the depreciation cost yearly.