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Here are some insights from the field of Accounting on the topic of Depreciation:
The Financial Accounting Standards Board (FASB) Generally Accepted Accounting Principles (GAAP) provide the rules for depreciation expense within accounting records. Deferred reporting of the entire cost of asset year-one, enables a company to benefit from depreciation while generating revenues from property-plant-equipment (PPE) and other operating assets in the meantime. The depreciation rate represents the total depreciation assessed, annually as a percentage of useful life throughout its life expectancy. Internal cost accounting methods (i.e. estimation of production runs) may impact depreciation reporting of machinery and other large assets. The difference between the original cost and the estimated accumulated depreciation over a period accounts for the remaining “carrying value” or “salvage value” of an asset. The record of depreciation allows for a business to write-off asset losses from taxes in the form of a deduction.
The matching principle of GAAP defines depreciation as the record of expense corresponding to a company’s use of an asset during its life expectancy, and its cost allocation. Although CFO or CPA accounting of financial record may include accelerated (i.e. final estimation) or accumulated depreciation (i.e. specified date) methods, the straight-line depreciation method is required under GAAP for the purpose of auditing.
Method selection has an indirect impact on the statement of cash flows of a company, as depreciation affects taxable income, or the opportunity to defer income tax payment into the future. The five different methods for calculating asset depreciation under GAAP all have the same result, yet with different timings depending on the selection:
1) Straight-line method;
2) Units of production method;
3) Declining balance method;
4) Double declining balance method; and
5) Sum of years' digits.
The most common accounting application for reporting the depreciation of assets, the straight-line method assigns equal depreciation expense across the years during the actual useful life, or until it has reached its salvage value.
If depreciation of an asset’s useful life is estimated as $4,000 ($6,000 cost - $2,000 salvage value), the straight-line method is employed to calculate the depreciable amount over the 5-year period, at $800 per year, the depreciation rate being 20 percent ($800/$4,000). The same method of obtaining the depreciation rate is applied to the estimation of the declining balance and double-declining balance (DDB) depreciation calculations as well.
This method requires the estimated total units an asset will produce over its useful life and calculates depreciation expenses based on a depreciable amount.
Calculating depreciation based on estimated unit production over the useful life of the asset and historical data, takes machinery deterioration into account. Depreciation expense is then calculated per year based on the number of units produced.
Cost basis of fixed asset - salvage value / Units to be produced over its estimated useful life.
In an accelerated depreciation accounting technique, the declining balance method allows a company to depreciate PPE based on a straight-line depreciation model. This method applies a multiplier to the percentage of remaining depreciable asset value each period. Because the carrying value of an asset is higher in earlier reporting cycles, the same percentage of depreciation expense declines annually.
Applying the straight-line method, PPE purchased for $5,000 is estimated as having a salvage value of $1,000 during a 5-year life span, and 20% depreciation rate each reporting period. If there is an expense of $800 in the initial year (($4,000 - $800) * 20%), this amount will define the estimation of depreciation the second year, and subsequent reporting periods to year five.
Another accelerated depreciation method, the Double Declining Balance (DDB) doubles the reciprocal of the useful life of the asset. The DDB is the rate applied to the book value of a company, and reflects remainder of the depreciable base of an asset’s expected life.
The reciprocal value of an asset with the useful life of five years at 1/5 or 20 percent of its original value is doubled. In this example, the rate of 40 percent is then applied to the current book value. Although the DDB rate remains constant, the value of the asset will decrease over time as the rate is multiplied by the incrementally lessening depreciable base each reporting period.
Sum-of-the-Year's-Digits (SYD) Method
The Sum-of-the-Year's-Digits (SYD) method calculates accelerated depreciation by way of fractional calculation of the digits (period) of the asset’s life expectancy.
To reach the sum of the year’s digits for an asset with a five-year life span, calculate 1+ 2 + 3 + 4 + 5 = 15 the first depreciation year, where the (period)/(sum of digits) is 5/15 or 20 percent of the depreciable base is subject to consecutive calculation of each year, with the second year defined by 4/15 of the depreciable base. The computation for this method continues to the 5th year, thus depreciating the remaining 1/15 or 6.7 percent of the asset’s value.
In accounting practice, asset acquisition has the potential to reduce cash and/or increase accounts payable. Accumulated depreciation is defined as a contra asset account, meaning the net asset value is reduced by a credit. Depending on the value estimation of an asset at the end of useful life, the calculation of book depreciation for all capitalized assets not fully depreciated will be reported by a CFA or CPA at the end of the reporting period.
Journal entry records consists of a debit to depreciation expense on the income statement, and a credit for accumulated depreciation on the balance sheet. The carrying value is the net of the asset account and accumulated depreciation. The salvage value is the carrying value that remains on the balance sheet after all depreciation has been taken until the asset is sold or otherwise disposed.
It is important to note depreciation expense deductions vary based on the estimated useful life of the particular asset. Depreciation is defined as “non-cash” within the accounting record, rather than as actual cash outflow. Threshold setting for depreciation reporting of a fixed asset or PPE is discretionary. Although an asset may be entirely paid for, the expense reporting of its depreciation may extend multiple years within a company’s audited financial statements.
GAAP vs. IRS Definition
The United States Internal Revenue Service (IRS) provides that companies must account for depreciation expenses within their tax reporting. IRS rules specify the schedule of deduction for companies may vary over time. The Modified Accelerated Cost Recovery System (MACRS) depreciation model is required by the IRS for business income tax reporting. The depreciation model of distribution assigns a proportional depreciation allowance based on the MACRS index of sequential tax reporting years. The MACRS formula depreciates an asset to a residual value of $0 and does not recognize carry over or salvage value as practiced under GAAP. According to IRS rules, a company has the option of depreciating additional capital costs from the outset. This is distinct from GAAP straight-line depreciation methods, which delay reporting of the full depreciation value to the fourth tax reporting year of the 5-year depreciation cycle.
Houston, Grant. “GAAP vs. IRS Depreciation Methods.” BizFluent, Sept 26, 2017.
Thompson, Jayne. “Depreciation Accounting Rules as Per the US GAAP.” Sapling, Dec 30, 2019.
Tuovila, Alicia. “Depreciation.” Investopedia. Jan 31, 2020.
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