What is depreciation expense?
Depreciation expense is a financial accounting reporting practice, used primarily by businesses that pay tax on income. On the income statement, this expense appears as a charge against income subtracted from sales revenues to produce a lower reported income (lower profit, lower earnings).
These expenses are charged according to a depreciation schedule, thereby accounting 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.
This article defines and explains depreciation and its scheduling, with examples, in context with related terms and concepts.
- What is depreciation expense?
- How does depreciation lower reported income and tax liability?
- What can be depreciated?
- What is the difference between cash flow and. claimed depreciation expense?
- What are the roles of depreciable life, depreciable cost, and residual value in calculating depreciation expense?
- How are the frequently used depreciation schedules defined?
- How is depreciation expense found in spreadsheet implementation?
How does depreciation lowers reported income and tax liability?
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 appropriate schedule for the asset (see Schedules, below).
In the example income statement (Exhibit 1, 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 these expenses 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.
Exhibit 1. Sample Income Statement showing depreciation expenses in several loactions, depending on use use of the assets depreciated. Depreciation expenses lower reported Net Income, which lowers the tax liability on income.
Using rounded figures from the statement, the tax savings from depreciation is thus $230,000 that is:
$1,188,000 – $958,000 = $230,000.
This tax savings can also be estimated directly as the product of
the expense and the tax rate. With a tax rate on income of 35%, for example,
0.35*$659,000 = $230,650.
Notice also that the expense can appear in any of the main expense categories, depending on how the asset in question is used. Here they appear under Cost of goods sold, as Manufacturing overhead (for manufacturing equipment), under Selling expenses (for store equipment), and under General and administrative expenses (for 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 the 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.
What is the difference between cash flow and claimed depreciation expens?
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, thus lowering reported income across several years or more.
Although this expense is not real cash flow itself, it does bring a cash flow consequence each year of the depreciable life. Because these non cash expenses lower reported income, they brings a tax savings that is a real cash flow.
What are roles of depreciable life, depreciable cost, and residual value in calculating depreciation expense?
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 schedule used for the asset's 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 life, based on 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 life of 5 years, and depreciation must follow the MACRS (Modified Accelerated Cost Recovery System) 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 expense claim purposes, the original cost may include two components:
Original Cost of Asset = Deprec. Cost + Residual Value
Exhibit 2 shows how depreciable cost decreases over time, leaving only the residual value at the end of depreciable life. Only the depreciable cost component will contribute to the claimed expense across the years of depreciable life. The asset's residual value (sometimes called salvage value) remains at the end of its life. Residual value is the estimated net value of the asset that would or could be received if the asset were retired or scrapped.
Exhibit 2. The figure shows how an asset originally costing $100 decreases in book value to its residual value over its depreciable life, as the expense is charged each year (the example follows a straight line schedule 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 Schedules, below, for more on these methods). Under DDB and MACRS, the expense percentages are applied against total original cost.
When using any schedule besides DDB and MACRS, residual value plays an important role in determining the claimed expenses, tax savings 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.
The length of an asset's depreciable life and the amount of depreciation a company can claim for it each year, are given by schedules. Tax laws in each country specify which schedules can be used for various classes of assets, although in some cases the company has a limited range of schedule choices.
Straight line schedule (SL)
The simplest schedule, so-called straight line depreciation spreads the expenses evenly across an asset’s depreciable life: A $100 asset fully depreciated over 5 years (and having no residual value) would allow the owner to claim a $20 expense each year for five years.
Other time-based schedules described below are called accelerated 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
related tax savings in the early part of the asset's
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 an accelerated schedule, 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 schedules for different asset classes: a General Schedule (GDS) which is most frequently used, and an Alternative 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 schedule that prescribes an annual rate twice that 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.
The sum-of-the-years'-digits schedule (SOYD) is an accelerated method 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 year’s rate becomes 5/15 of the depreciable cost (33.3%), the second year’s rate is 4/15 of that cost (26.7%), the third year’s rate 3/15, and so on.
The table below compares depreciation percentages applied each year with the depreciable cost of an asset having a 5-year life. Figures in the table show percentage depreciated per year. These schedules are shown graphically below the table.
|Schedule||Year 1||Year 2||Year 3||Year 4||Year 5||Year 6|
|Double Decl. Bal.||40.00||24.00||14.40||8.64||5.18||—|
|Sum of Years Digits||33.33||26.67||20.00||13.33||6.67||—|
Exhibit 3. Four depreciation schedules compared: Straight line SL vs. MACRS vs. DDB vs. SOYD
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 "life" as a fixed period of time, charging a given percentage of depreciable cost each year as an expense. Note, however, that sometimes, so called usage-based depreciation is permitted. A vehicle under this plan, for instance, might have its life defined not in years, but in terms of total miles or kilometers driving expected during its life. The expense claimed each year would reflect the distance traveled that year as a percentage of the lifetime total. Similarly, other kinds of assets might have a scheduled life defined by a quantity that will be used up, in which case the expense percentage each year is based on the quantity used up.
Composite depreciation is a method 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 company’s office furniture, or office equipment. See the encyclopedia entry composite depreciation for an explanation and example.
How is depreciation expense found in 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 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 expense:
= (Asset A deprec. cost ) * ( SL percentage for Year 1 of 4 )
Year 2 Total expense:
= (Asset A deprec. cost ) * ( SL percentage for Year 2 of 4 ) +
(Asset B deprec. cost ) * (MACRS percentage for Year 1 of 6 )
By Year 4, Total expense:
= ( Asset A deprec. cost ) * ( SL percentage for Year 4 of 4 ) +
( Asset B deprec. cost ) * ( MACRS percentage for Year 3 of 6 ) +
( Asset C deprec. cost ) * ( DDB percentage for Year 2 of 8 ) +
( Asset D deprec. cost ) * ( SL percentage 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 these calculations across multiple years, in either