Depreciable assets are tangible assets that are used in a business. Over time, these assets decline in value because of wear and tear, aging, and obsolescence. Depreciation provides a way to match the decline in value with the income that results from using the assets.
Generally accepted accounting principles (GAAP) require a rational and systematic approach to depreciation, as well as consistent financial reporting. Accordingly, many decisions must be made to establish depreciation schedules and the proper recording of fixed asset transactions.
Read on to learn some basic strategies used to deal with depreciation, as well as some common depreciation methods. Your preparation will help you establish consistent accounting policies and procedures for your clients.
Your client must keep a record of all depreciable capital assets for his or her business. Known as a depreciation schedule, this list records the date that each asset was placed in service, a calculation for each successive year's depreciation, and accumulated depreciation.
An asset remains on a depreciation schedule until the asset becomes fully depreciated or is discarded. A year-end review of fixed assets ensures that your client's business does not keep assets that have been sold or abandoned on the schedules.
Before adding assets to your client's depreciation schedules, evaluate these issues:
- Basis The basis of an asset is usually its cost. Review invoices carefully to ensure that appropriate costs are included — don't forget to include costs such as delivery and setup in the value of the asset.
- Recovery period The recovery period of an asset is the number of years you expect the asset to remain in use.
- Salvage value The salvage value is the estimated value of the asset at the end of its estimated useful life. If you estimate a salvage value, you depreciate the asset down to the salvage value. Often companies do not estimate a salvage value, possibly because it's difficult to estimate or because some assets, such as computer hardware or software, become obsolete so quickly that they typically have only a negligible value at the end of their depreciable lives.
- Partial-year depreciation When an asset is placed in service at some time during the year, a partial depreciation charge is required. If, for example, you start using an item at midyear, you will take depreciation for half of a year in that year and for half of a year in the last year that it is depreciated. Options for handling partial-year depreciation include:
- Half year in the year that the asset is placed in service and also in the final year.
- Full year in either the year that the asset is placed in service or in the final year.
- Prorating by the month or quarter that the asset is placed in service, with the remainder of the depreciation taken in the final year.
- Expensing vs. depreciation Help your client establish a consistent approach for deciding whether the business should expense items that are inexpensive and perhaps not worth adding to the depreciation schedule. You might choose, for example, to expense all assets that cost less than $1,000.
Other depreciation considerations
Below are some other important depreciation-related items that you should consider when establishing your accounting policies and procedures.
- Abandonments If your client disposes of an asset, both the asset and the offsetting depreciation can be written off. Continue to claim depreciation for an asset if it is only temporarily idle.
- Assets from a lump-sum purchase If your client purchases several assets together, collect an appraisal that provides the fair market value for setting your basis. If you lack adequate information about fair market values for the assets, you must allocate the purchase price among the assets, as dictated by GAAP.
- Repairs vs. capital improvements Determine how to allocate repair and improvement costs to assets. Repairs and maintenance occur routinely and should be expensed. Improvements that extend the life of an asset to future periods are depreciable. For example, repairing a machine or replacing short-lived parts within a machine is considered a repair. Totally rebuilding a machine to significantly extend the machine's life is considered a capital improvement.
Depreciation methods vary for financial reporting and tax reporting. Although similar accounting fundamentals underlie both types of reporting, financial reporting emphasizes compliance with GAAP, whereas tax reporting provides various options for minimizing taxes due. Also, some depreciation methods may work better for certain types of business activities, so you need to know whether a particular depreciation method is a common practice within your client's industry.
A variety of depreciation methods are available for financial reporting. The type of depreciation method you choose can have a significant impact on your client's bottom line. Some financial reporting depreciation methods include:
- Straight-line method Depreciation charges are spread evenly over the life of an asset. Easy to calculate, the straight-line depreciation method is used by a majority of small businesses.
- Accelerated methods Accelerated depreciation methods include sum-of-years' digits and double-declining balance methods. Accelerated methods assume that an asset is used more heavily during the earlier years and loses a majority of its value during the first several years of use.
- Activity methods Activity depreciation methods assume that depreciation is a function of use. The life of the asset is valued according to the output the asset provides or the number of units of activity that it produces. Activity methods may provide an excellent matching of expense to income for a machine where the number of produced units can be estimated, but activity depreciation methods do not work for all asset types.
- Group or composite method The group depreciation method is appropriate for a large number of similar assets, such as utility telephone poles. The composite depreciation method is used for a group of dissimilar assets, such as a fleet of different types of vehicles. Both methods are based on an average depreciation rate for the group.
Most companies use the modified accelerated cost recovery system (MACRS) for tax reporting unless precluded by special circumstances. The MACRS permits greater accelerated depreciation over longer time periods. This faster acceleration allows businesses to deduct larger amounts during the first years of an asset's life.
MACRS depreciation is based on class life instead of useful life. The MACRS categorizes all business assets into classes and specifies the time period over which you can write off assets in each class. Different conventions are used for each asset class to adjust the first-year depreciation, depending on the asset's placed-in-service date.
These class life groups are predetermined by the IRS — for example, 3, 5, 7, 10, 15, 20, 25, and 27.5 years for residential real property, and 39 years for nonresidential real property. You will probably find that most of your client's assets, other than real estate, fall into the 5-year and 7- year categories. For example, most office items, such as typewriters, calculators, and copiers, are considered 5-year property, while most factory machinery is considered 7-year property.
Be mindful to avoid these common MACRS errors:
- Incorrect class life Make sure that you choose the correct class life for your asset.
- Improper averaging convention To avoid the complications of depreciating each asset from the specific date on which it was placed in service, averaging convention guidelines assume that various assets are placed in service or are disposed of at designated dates throughout the year. Make sure that you use the proper averaging convention — half-year, midquarter, or midmonth. Each convention follows a set of rules that is based on the type of asset that you are depreciating.
- Inappropriate use of the MACRS Be sure that your particular asset can be depreciated by using MACRS. Some assets, such as tax-exempt bond-financed property, require another method of depreciation.
- Depreciating when expensing would be better Confirm that it's in your company's best interest to depreciate an asset. You may fare better by taking advantage of a special deduction called Section 179, which allows you to deduct 100% of the cost of some depreciable assets in the year that you buy them.
Understanding the rules and methods of depreciation can be daunting. If you are setting up depreciation schedules for your client for the first time, review the standards for your client's industry. You may want to review your GAAP guide, an accounting text, and the Internal Revenue Service Publication 946 (How to Depreciate Property). Establishing clear and consistent depreciation accounting policies will help ensure that your clients are prepared for tax implications when they are planning capital equipment purchases.