Depreciation Expense – non cash but is it important?

Depreciation Expense – non cash but is it important?

MEANING OF DEPRECIAITON EXPENSE

Every business needs certain fixed assets like Building, vehicles, plant and machinery, Laptops etc. to carry out its operations smoothly and to be more productive. Every year large corporates spend heavily on fixed assets also known as capital assets to enhance its productivity in the long run. However, these fixed assets are bought by the company to serve its operations over a longer period of time generally for more than one year. These assets should be capitalized in the books of accounts instead of expensing it off right away in the accounting period in which it is purchased. These assets provide returns beyond the initial accounting period and has a longer economical useful life. Expensing it off in the year of purchase shall overstate the income of that year and understate the income of the remaining years in which it is actually used to generate revenue.

Hence Depreciation is an example of the matching principle of accounting. One of the basic principles of Generally Accepted Accounting Principles is expenses should be recognized in the same period as the revenue is generated rather than when they are paid. Depreciation is a non-cash expense that allocates the purchase of fixed assets over its estimated useful life. Since depreciation expense has as significant impact on the company’s tax liability and financial statements it is important to accurately calculate the depreciation.

ASSETS WHICH CAN BE DEPRECIATED

Companies need different type of assets in day to day functioning and are classified according to their nature of use and their useful economic life. Broadly there are two type of assets used in any business: They are Fixed assets (Capital assets) and Current assets.

Capital Assets: Assets that are purchased or otherwise controlled by a business and are used to generate revenue in a company’s business operations over the course of more than one year. Capital assets can be tangible (plant & machinery, building) or intangible (patents, copy writes). Tangible assets also known as fixed assets are initially recorded in the Balance sheet as Asset and later on expensed over the useful life of the asset through a process called depreciation. However, the intangible assets are not depreciated but expensed off gradually like fixed assets through a process called amortization.

As per accounting, each company sets its own threshold for determining whether to depreciate an asset or expense it off immediately in the year of purchase. However, the IRS (Internal Revenue Service) issues a threshold amount beyond which assets should be capitalized.

Land is also a fixed asset however is an exception to this rule and is not subject to depreciation since it is considered a non-depleting asset that has an infinite life, does not wear or tear and never becomes obsolete.

Current Assets: Those assets which can be converted to cash within one year and hence are short term in nature. Examples are cash and cash equivalents, accounts receivable, inventory, marketable securities etc. These assets are not depreciated.

WHEN DOES DEPRECIATION EXPENSE BEGIN AND END?

Companies begin to depreciate their assets when they place it for use in their business or for the production purpose and stop depreciation when they have either fully recovered their cost or when they retire it from service, whichever happens first.

INPUTS REQUIRED IN DEPRECIATION CALCULATION

Depreciation calculation require determination of the following inputs

  1. Initial cost of an asset– Cost of assets include all the cost involved in its acquisition, installation and commissioning. It involves all the expenses involved in purchasing the asset and putting them into use.

It includes the following:

  • Purchase price of the asset
  • Freight and handling expenses,
  • Costs of dismantling, removing or clearing a site for installation,
  • Directly attributable expenses to bring the asset to working condition,
  • Site preparation cost,
  • Installation and assembly costs,
  • Testing cost to check whether the asset is in proper working condition
  • Fees payable to professionals like architects or engineers for installation.
  • Import duties paid like custom duty
  • Initial delivery cost,
  • handling costs,

We cannot include any cost incurred after the machine is ready for use like cost incurred in production for captive consumption or for sale, any further administrative expenses, cost incurred for its inauguration or for promotional activities.

However, we can include all major improvements and upgrades to the cost of the asset since they improve the assets useful life or its production capacity.

2. Useful life of the asset- It is an accounting estimate of the number of years any depreciable asset will remain in profitable service of the business. The purpose of a useful life estimate is to determine the amount of depreciation to be charged to Income statement to make the revenue generated by the given asset.

As per Internal Revenue Service (IRS) for tax purposed business have to use modified accelerated cost recovery system (MACRS) method to calculate depreciation. MACRS suggest that companies should use useful life that are published by IRS for various different class of assets. (discussed later in the article).

In case of any upgradation of assets the useful life of the asset may increase and in case of any unpredictable future event the useful life of an asset needs to be lowered than before.

3. Salvage value of the asset: The amount that an asset is estimated to be worth at the end of its estimated useful life is called as the salvage value often also termed as the scrap value or residual value. It is used in calculation of the annual depreciation expense. If the salvage value is set too high or too low, it can be having adverse impact on the financial statements. The IRS requires a company to estimate a “reasonable” salvage value depending on how long the company expects to use the asset and how regressively the asset is used. A company may set lower or zero salvage value if the asset is expected to be used till the end of its useful life or is prone to obsolesce due to its nature. However, if the company expects to sell it before its useful life it can set a higher salvage value.

IMPACT OF DEPRECIATION IN DIFFERENT BUSINESS

Since depreciation is a non-cash charge in the income statement it impacts the bottom line of the company i.e., the net profit and even the Earnings per share. Its calculation becomes more important since it has tax impact as well. Higher the depreciation lower is the Net Taxable profit and lower the tax to be paid. If a company has a large asset base like aircraft companies invest major part of their funds in huge and costly aircrafts, manufacturing companies have to set up huge factories and invest in new technology machines, the depreciation for these companies account for major expense in the income statement. On the other hand, software and technology companies record a small amount as depreciation since they have more of man power than depreciable fixed assets.

IndustryCompany NameDepreciation recoded
ManufacturingCoca Cola$1,260 ( in millions)
ManufacturingPepsiCo$2,763 ( in millions)
AirlinesDelta Airlines$2,107( in millions)
Source : Company website FY 2022

Source: Annual report of the companies on their respective company websites

DEPRECIATION AND ACCUMULATED DEPRECIATION

Depreciation is an annual charge to the Income statement which reduces the net profit of the company. On the other hand, Accumulated depreciation impacts the Balance Sheet and reduces the net Assets of the company. Accumulated depreciation is a contra asset account. The depreciation expense is debited to expense and credited to accumulated depreciation account. Accumulated depreciation account has credit balance as it offsets the fixed assets each time depreciation is recorded in the books. Balance sheet represents Net Assets which is Gross Assets minus Accumulated Depreciation. Depreciation also impacts the cash flow statement. Since depreciationis a non-cash expense it is added back to the net income while calculating the cash flows. Net income excludes depreciation and that’s why it is added back.

DEPRECIATION SCHEDULE

Whenever a company purchase any asset it has to maintain a depreciation schedule that has various elements and shows a detailed timeline of depreciation expense recorded and its net asset value. This schedule is based on company’s existing asset schedule.

Depreciation schedule includes components like:

  • Name and description of the asset
  • Date of its purchase
  • Cost of asset acquisition
  • Method of depreciation used
  • Estimated Useful life and salvage value

DIFFERENT METHODS OF DEPRECIATION

There are 5 commonly used methods of depreciation:

  1. Straight line depreciation: It is a time based method in which the asset is evenly depreciated over the useful life of the asset. It is commonly used for those assets which are expected to provide equal benefits over the useful life. Building is commonly depreciated using straight line method of depreciation.

FORMULA

               Depreciation= (Cost- Salvage Value)/ Estimated Useful life of the Asset

               Example:

               ABC Ltd purchases a Building for $ 100,000

                Salvage value: $50,000

                Depreciable base: $100,000 – $ 50,000 = $ 50,000

                Useful life: 10 years

                Solution: Company has to record annual depreciation of $(100,000-50,000)/10 = $5,000

                Depreciation Schedule of the asset

YearDepreciationNet Fixed Asset BalanceAccumulated DepreciationGross Fixed Asset Balance
Opening Balance 100,000  
Year 15,00095,0005,000100,000
Year 25,00090,00010,000100,000
Year 35,00085,00015,000100,000
Year 45,00080,00020,000100,000
Year 55,00075,00025,000100,000
Year 65,00070,00030,000100,000
Year 75,00065,00035,000100,000
Year 85,00060,00040,000100,000
Year 95,00055,00045,000100,000
Year 105,00050,00050,000100,000

                   Journal Entry

                  The company shall pass an annual journal entry to record depreciation expense as follows:

 AccountAmount
DebitDepreciation expense5,000
CreditAccumulated Depreciation5,000

                 Impact in Balance Sheet

ParticularsYear 1Year 2Year 3
Building100,000100,000100,000
Less: Accumulated Depreciation5,00010,00015,000
Net Asset (Building)95,00090,00085,000

                 By the end of 10 years, the Building will stand at $50,000 i.e. the salvage value.

  • Units of Production: In this activity based method the depreciation expense is tied to the amount of output the asset is estimated to yield. It is useful for industries where the productivity varies significantly. Mining industries commonly use this method since mining operations can result in production varying significantly over different years.

               FORMULA

               Depreciation= [(Cost- Salvage value)/Total Estimated Production] * Units produced this year

               Example:

               Company A buys a mining machine worth $100,000

               Residual Value: $ 10,000

               Total Estimated production: 95000 units

               Total produced units in year 1: 5000 units

               Solution: Depreciation= [(100,000-10,000)/95000] *5000 = $4,737

  • Declining Balance: The asset is depreciated by the same rate over the useful life of the asset for each accounting year. This method is used for those assets that depreciates faster in the earlier years for example vehicles tend to depreciate faster in the initial years. It is also known as accelerated depreciation method.

FORMULA

               Depreciation= (1/Useful Life) * (Cost- Accumulated Depreciation)

             Example:

             A machine is purchased for $10,000

             Useful life: 5 years

             Solution: Depreciation in 1st year= ($10,000*1/5) = $5,000

                              Depreciation in 2nd year= ($10,000-$5,000) *1/5 = $1,000

  • Double-Declining Balance: It is an even more accelerated method than declining balance method. It uses multiplier 2 to twice the amount of depreciation.

FORMULA

               Depreciation= (2/Useful Life) * (Cost- Accumulated Depreciation)

               Example:

               A machine is purchased for $10,000

              Useful life: 5 years

              Solution:  Depreciation in 1st year= ($10,000*2/5) = $4,000

                              Depreciation in 2nd year= ($10,000-$4,000) *2/5 = $2,400

  • Sum-of-Years’ Digits: This is also an accelerated method of depreciation. First in this method we add up all the digits of the expected life of the asset. If the life of asset is 5 years, then we will add (1+2+3+4+5) = 15. In the first year depreciation would be 5/15 of the cost minus salvage value. In the second year it would be 4/15 of the depreciable base and so on.

FORMULA

YearMultiplying factor
15/15
24/15
33/15
42/15
51/15


               Example:

               A machine is purchased for $10,000

               Useful life: 5 years

               Solution:  Depreciation in 1st year= ($10,000*5/15) = $3,333

                              Depreciation in 2nd year= ($10,000*4/15) = $2,667

DIFFERENCE BETWEEN BOOK DEPRECIATION AND TAX DEPRECIATION

Depreciation is often calculated differently for accounting purpose and for tax purpose.

Book Depreciation: It is the depreciation that is calculated as per US GAAP or IFRS. This depreciation is a non-cash expense and has no impact on the actual cash flow of the company. It is an expense that is reflected on the income statement and reduces the Net income of the company. There is no fix method that is prescribed to be used to calculate Book depreciation. The threshold above which an asset should be depreciated depends upon the discretion of the company.

Tax Depreciation: Tax depreciation has to be calculated based on rules set by IRS. As per IRS companies should use modified accelerated cost recovery system (MACRS). Higher depreciation expenses are calculated as per MACRS in the early years of an asset’s life. This in turn creates a higher tax deduction and lower taxable income for the company. MACRS used straight line and double declining balance method to calculate depreciation amount. However, it required companies to adopt the useful lives of the assets that are determined and published by the Internal Revenue Service. The IRS sets guidelines for the threshold limit above which the asset should be depreciated.

The assets are depreciated to zero under IRS as MACRS do not consider the salvage value. Due to this reason it is not approved by the GAAP.

Assets and Useful Life in Years as per MACRS:

Description of AssetsUseful Life (Years)
Tractors, racehorses, rent-to-own property, etc.3
Automobiles, buses, trucks, computers, office machinery, breeding cattle, furniture, etc.5
Office furniture, fixtures, agricultural machinery, railroad track, etc.7
Vessels, tugs, agricultural structure, tree or vine bearing fruits or nuts, etc.10
Municipal waste water treatment plant, restaurant property, natural gas distribution line, land improvements, such as shrubbery, fences, and sidewalks, etc.15
Farm buildings, certain municipal sewers, etc.20
Water utility property, certain municipal sewers, etc.25
Any building or structure where 80% or more of its gross rental income is from dwelling units27.5
An office building, store, or warehouse that is not residential property or has a class life of less than 27.5 years39

Source : (https://www.irs.gov/publications/p946#en_US_2022_publink1000107576)

SUMMARY:

Since depreciation accounts of a major expense in the income statement it needs to be evaluated carefully so that it reflects true and fair view in the financial statements and also take tax consideration into account. The first step is choosing the most appropriate depreciation method suitable for the company.

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4 thoughts on “Depreciation Expense – non cash but is it important?”

  1. […] and Amortization: Depreciation is a result of the company’s historical investments and depend heavily on assumptions like the […]

  2. […] and amortization expense: Cost of Fixed assets i.e. depreciation expense and amortization of intangibles recorded in the books of accounts written off over a period of time […]

  3. […] but straight-line depreciation for financial reporting. Under the accelerated depreciation method, depreciation expense is higher in initial years and lower in subsequent years. This results in lower taxable income than […]

  1. flange manufacturer in mumbai March 24, 2024

    Thanks again for the blog article.Much thanks again. Really Cool.

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