Depreciation is an annual allowance allowed for usage of a capital asset. A taxpayer will deduct the cost of a capital asset by depreciating it.
Land is not a depreciable asset.
Most other assets like building, machinery, vehicles, furniture and equipment are depreciable. Intangible assets like incorporation cost, patents, copy rights and computer software depreciable.
If a company has assets their value will decrease. We need to change a line item in the balance sheet because this decrease. We record this reduction as depreciation expense. This transaction will reduce income and eventually decrease retained earnings.
Example:
Let us take an example of an asset that has depreciation expense of $5,000.00 Depreciation expense reduces net income after taxes as we see in this example. Net income drives the cash flow statement, but since depreciation is a non-cash expense, it is added back to cash.
Income Statement:
Depreciation = (5,000)
Taxes @ 40% = 2000
Net Income = (3000)
Cash Flow:
Net Income = (3,000)
Depreciation = 5,000
Total Change in Cash = 2,000
Balance Sheet:
Cash = 2,000
Assets = (5,000)
Retained Earnings = (3,000)
Methods of Depreciation:
There are several different methods allowed to depreciate assets. Each has its own benefits under certain conditions.
Straight Line:
This method will evenly age an asset for its expected life. For example, if we buy an asset for $50,000 and it has a useful life of 10 years, depreciation expense for each year will be $5,000 (50,000 / 10 = 5,000)
In ten years value of this asset will equal to zero because it will be fully depreciated.
If an asset is assigned a residual value then after 10 years its value will equal assigned residual value. Residual value is a minimum value assigned to an asset after its useful life. So for example, if we assume residual value to be equal to $1,000, the asset will be worth $1,000 after its life of 10 years.
Therefore depreciation expense for our asset in above example will be $4,900 each year instead of $5,000.
Formula for straight line depreciation = (Fair value of asset – Residual value ) / useful life.
Accelerated Depreciation:
This method allows greater depreciation each year. It will produce lower taxable income. Following are few methods for accelerated depreciation:
- Declining Balance
- Modified Accelerated Cost Recovery System (MACRS)
Declining Method:
This method takes a percentage of net property balance each year. The percentage applied is calculated by dividing 1 by the life of asset times an accelerating multiplier. A common multiplier is 2.0
So for our asset of 50,000 with life of 10 years, if we take multiplier of 2.0 our declining percentage becomes 1 / 10 x 2 = 20%
Following is an example of declining balance depreciation:
Sum of the year’s digits:
For this method we take the sum of digits from 1 to the life of an asset. In our example we assume life of asset = 10 years. Hence sum = 1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 + 9 + 10 = 55
Year 1 Depreciation = 10 / 55 x 50,000
Year 2 Depreciation = 9 / 55 x 50,000
Year 3 Depreciation = 8 / 55 x 50,000
Year 4 Depreciation = 7 / 55 x 50,000
Year 5 Depreciation = 6 / 55 x 50,000
Year 6 Depreciation = 5 / 55 x 50,000
Year 7 Depreciation = 4 / 55 x 50,000
Year 8 Depreciation = 3 / 55 x 50,000
Year 9 Depreciation = 2 / 55 x 50,000
Year 10 Depreciation = 1 / 55 x 50,000
Modified Accelerated Cost Recovery System (MACRS):
This is U.S tax method for depreciation. The MACRS method is a predefined set of percentages based on asset’s useful life. These percentages are applied to the base value of the asset each year.
There are several conventions used in this method depending on when the asset is placed in service. Following is an example of half year convention which assumes asset is not placed in service until mid-year.
The mid-year convention assumes that the asset is not placed in service, and so does not start depreciating until mid-year. This is why first years percentage is lower (33.33%) than the next year’s percentage of 44.45%.
Above is a table of mid-quarter convention. It assumes that the asset starts depreciation in the middle of the quarter. Therefore, starting percentage of 58.33% is higher than that of the half year convention. Because the asset is placed in service in the first quarter it begins depreciating earlier.
Deferred Taxes:
A deferred tax item is used to reduce a company’s income tax. A deferred tax item is created after receiving a net operating loss (NOL). The IRS allows a company to offset the loss against taxable income in another year.
The NOL can be carried back 2 to 5 years or carried forward up to 20 years.
 NOL Carry Back Example:
This company had a loss in the year 2012. They applied for two year carry back. It allowed company to offset 2012 losses by receiving a refund on taxes paid in prior two years.
NOL applied in 2010:
Beginning balance = 1,000
Taxable Income = 750
Tax refund 40% = 300
NOL balance = 250
NOL applied in 2011:
Beginning balance = 250
Taxable income = 1,500
Tax refund 40% = 100
NOL balance = 0.00
Disclaimer:
This information is for educational purposes only. It does not constitute any legal advice or opinion. Please do not use any of its contents without seeking a professional advice.
References:
Financial modeling and valuation by Paul Pignataro
Mansoor Suhail (Mani)
Accountant
BSBA – EA – ICIA – RA
Tax for Canada and U.S.A
Web: www.theaccountingandtax.com and www.taxservicesguru.com
Blog:Â http://taxservicesguru.blogspot.ca
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