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Theories are rarely as simple in real life as they are on paper, and this one is no exception. Do you divide the cost evenly across the asset’s lifetime, or do you charge more to certain years than others? Furthermore, when it eventually comes time to dispose of fixed assets, the assets may have some disposable, or salvage, value. In theory, only cost minus the salvage value should be depreciated. But in actual practice, most companies ignore salvage value, and the total cost of a fixed asset is depreciated. Moreover, how do you estimate how long an asset will last in the first place? Do you consult an accountants’ psychic hotline?
As it turns out, the Internal Revenue Service runs its own little psychic business on the side, with a crystal ball known as the Internal Revenue Code. Okay, so the IRS can’t tell you that your truck is going to conk out in five years, seven months, and two days. The Internal Revenue Code doesn’t give you predictions of how long your fixed assets will last; it tells you what kind of timeline to use for income tax purposes, as well as how to divide the cost along that timeline.Hundreds of books have been written about depreciation, but the book that really counts is the Internal Revenue Code. Most businesses adopt the useful lives allowed by income tax law for their financial statement accounting; they don’t go to the trouble of keeping a second depreciation schedule for financial reporting. Why complicate things if you don’t have to? Why keep one depreciation schedule for income tax and a second for preparing your financial statements? That said, it may be a different story for some large companies.
The IRS rules offer two depreciation methods that can be used for particular classes of assets. Buildings must be depreciated one way, but for other fixed assets, you can take your pick:- Straight-line depreciation: With this method, you divide the cost evenly among the years of the asset’s estimated lifetime. Buildings have to be depreciated this way. Assume that a building purchased by a business costs $390,000, and its useful life — according to the tax law — is 39 years. The depreciation expense is $10,000 (1/39 of the cost) for each of the 39 years. You may choose to use the straight-line method for other types of assets. After you start using this method for a particular asset, you can’t change your mind and switch to another depreciation method later.
- Accelerated depreciation: This term is a generic catch-all for several methods. What all these methods have in common is the fact that they’re front-loading, meaning that you charge a larger amount of depreciation expense in the early years and a smaller amount in the later years. The term accelerated also refers to adopting useful lives that are shorter than realistic estimates. (Few automobiles are useless after five years, for example, but they can be fully depreciated over five years for income tax purposes.)
The salvage value of fixed assets (the estimated disposal values when the assets are taken to the junkyard or sold off at the end of their useful lives) is ignored in the calculation of depreciation for income tax. Put another way, if a fixed asset is held to the end of its entire depreciation life, its original cost will be fully depreciated, and the fixed asset from that time forward will have a zero book value. (Recall that book value is equal to original cost minus the balance in the accumulated depreciation account.)
Fully depreciated fixed assets are grouped with all other fixed assets on external balance sheets. All these long-term resources of a business are reported in one asset account called property, plant and equipment (instead of the fixed assets). If all the fixed assets were fully depreciated, the balance sheet of a company would look rather peculiar; the cost of its fixed assets would be offset by its accumulated depreciation. Keep in mind that the cost of land (as opposed to the structures on the land) isn’t depreciated. The original cost of land stays on the books as long as the business owns the property.The straight-line depreciation method has strong advantages: It’s easy to understand, and it stabilizes the depreciation expense from year to year. Nevertheless, many business managers and accountants favor an accelerated depreciation method to minimize the size of the checks they have to write to the IRS in the early years of using fixed assets. This method lets the business keep the cash for the time being instead of paying more income tax. Keep in mind, however, that the depreciation expense on the annual income statement is higher in the early years when you use an accelerated depreciation method, so bottom-line profit is lower. Many accountants and businesses like accelerated depreciation because it paints a more conservative picture of profit performance in the early years. Fixed assets may lose their economic usefulness to a business sooner than expected, and in this case, using the accelerated depreciation method would look very wise in hindsight.
Except for new enterprises, a business typically has a mix of fixed assets — some in their early years of depreciation, some in middle years, and some in later years. There’s a balancing-out effect among the different vintages of fixed assets being depreciated. Therefore, the overall depreciation expense for the year under accelerated depreciation may not be too different from the straight-line depreciation amount. A business doesn’t have to disclose in its external financial report what its depreciation expense would have been if it had used an alternative method. Readers of the financial statements can’t tell how much difference the choice of accounting methods would have caused in depreciation expense that year.