We have made it through a couple of weeks of devoting our Tuesday feature article to the new QuickBooks 2017, but this week we return to Accounting Tips.
Last time, I promised we'd begin a dive into the topic of depreciation from other than a posting standpoint. So, this week, I want to begin by briefly discussing the differences between "book depreciation" and "tax depreciation."
Book versus Tax Depreciation
Book depreciation is the amount recorded in your books and reported on your financial statements, based upon the matching principle of accounting. The methods used are intended to as closely as possible value the economic benefit of the asset against its useful life.
Tax depreciation represents the amount reported on the company’s income tax returns. It is based upon the rules of the Internal Revenue Code applicable to the company’s assets.
Tax law can differ significantly from book depreciation practices when it comes to allowed depreciation for tax reporting purposes. For example, the tax code may permit certain types or classes of assets to be depreciated – for tax purposes – under an accelerated method, or perhaps, even immediate expensing in which the entire value of the asset is deducted from taxable income in the year in which it's purchased.
Differences in accounting rules for financial (book) and tax reporting purposes commonly results in differences in the amount of depreciation recorded on the books – even the amount of income reported for any given accounting period. This is why it's necessary to reconcile the differences in book and taxable income each year when preparing annual tax returns.
Because the scope and nature of such reconciliations vary on the business entity type for tax reporting purposes, as well as the book versus taxable depreciation methods, a discussion of the reconciliation methodology is beyond the scope of this mini-series.
Classic Book-value Depreciation Methods
With a basic understanding of the differences between book and tax depreciation behind us, let’s define several "textbook" methods used for the computation of book depreciation:
- Straight-line Depreciation – the same depreciation is expensed over the entire useful life of the asset
- Declining-balance Depreciation – the depreciation expense decreases at a constant rate as the useful life of the asset diminishes
- Sum-of-the-year’s Digits Depreciation – the depreciation expense decreases by a constant amount as the life of the asset progresses
- Units-of-activity Depreciation – the depreciation expense varies by period in proportion to usage or output of the asset
Each of these methods has distinct advantages and disadvantages, which we will examine as we look more closely at each methodology.
The Straight-line Depreciation method expenses the same amount over the entire useful life of the asset. Please recall we defined "useful life" in Part 2 of this mini-series.
When you expect to realize the benefits of an asset on a nearly even basis, over its use life, this method probably is the most appropriate.
This method also tends to be the most common method used, because it doesn’t require you to estimate any patterns of expected economic benefit of the asset over its lifetime.
Straight-line depreciation can be computed using the formula:
Annual Depreciation = Cost – Residual Value / Useful Life
We actually computed a straight-line depreciation computation in our Part 2 article as well. It actually was a bit more complicated, because we had portions of years involved, so we had to apportion the depreciation expense over six different fiscal years.
But we need to cover the fundamentals of this method, so we're going to use the same "asset" in a more simplistic example here.
In this scenario, we purchased a dongle die on Jan. 1, and we estimated it had a five-year useful life. The cost of the dongle die was $1,000.00. We also determined that the dongle die would have a residual value of $100 at the end of five years.
So the following numbers get plugged into the formula above to determine our annual depreciation expense using the straight line method for a full five years:
$1,000 - $100 / 5-years = $180.00 in Depreciation Expense per year
In this case, unlike the example we set forth in Part 2, we don't have to apportion any of the depreciation expense, since the asset was available for every day of the entire five-year period.
Advantages of Using Straight-line Depreciation
- Extremely easy to compute
- Useful where asset’s economic benefit pattern is difficult to determine
- Best suited for assets that provide essentially the same economic benefit over their entire useful life.
Disadvantages of Using Straight-line Depreciation
- May not reflect the actual pattern of an asset’s economic benefit over its lifetime.
This method, sometimes known as the double-declining balance method, or 200 percent declining balance method, is a common form of accelerated depreciation. This method expenses depreciation at a higher rate during the earlier years of an asset’s useful life, resulting in declining depreciation expenses as the life of the asset progresses.
Even though the depreciation computed under this method will be faster, the total depreciation of the asset will not exceed the total depreciation expensed using the straight-line method of depreciation.
When you can realistically determine that the economically beneficial value of an asset diminishes over its useful life, this may be the most appropriate method for computing annual depreciation.
Declining-balance depreciation can be computed using the formula:
Annual Depreciation = Net Book Value – Residual Value X Rate%
In using this formula, the Net Book Value represents the asset’s net value at the beginning of each accounting period, and is computed by reducing the total accumulated depreciation from the cost of the asset.
The Rate should reflect the estimated pattern of an asset’s use over the useful life.
So let’s apply this declining-balance method to the computation of our dongle die under the same assumptions as before.
The dongle die was bought on Jan. 1, at a cost of $1,000 and it has a residual value of $100 at the end of its five-year useful life. We also are going to estimate that the pattern of the dongle die’s use over its lifetime is 50 percent.
So, let’s plug these numbers in for each year of depreciation:
Year 1: $1,000 - $100 X 50% = $450
Year 2: ($1,000 - $450) - $100 X 50% = $225
Year 3: ($1,000 - $675) - $100 X 50% = $112.50
Year 4: ($1,000 - $787.50) - $100 X 50% = $56.25
Year 5: ($1,000 - $843.75) - $100 X 50% = $56.25*
* The depreciation expense during the final year of an asset’s useful life, when using the declining-balance method, is the difference between the book value at the start and the estimated residual value to ensure that the accumulate depreciation represents the full value of the asset less the residual value.
Advantage of Using Declining-balance Depreciation
- Most appropriate where an asset’s economic benefit declines more appreciably over its early life as opposed to its later life
Disadvantages of Using Declining-balance Depreciation
- Bias may enter into an estimate of the rate of depreciation used in computation of the annual depreciation.
Next time, we will look at the methods of Sum-of-the-year’s Digits Depreciation and Units-of-activity Depreciation.