Bookkeeping – Estimating Depreciation (Lesson 83)

Depreciation is a form of an allowance for the wear and tear (exhaustion) of property used in a trade or a commercial enterprise. The idea is to match as well as possible the actual use (utility) of the asset  to its change or reduction in fair market value due to that utility. This estimate is necessary to fairly state the profit on the income statement (overstated depreciation reduces profit) and the value of the fixed on the balance sheet (an understatement of depreciation gives the impression the asset is worth more on the balance sheet).

The accountant needs to understand that this estimating process will never be accurate; the goal is to get it as close as possible. There is a big difference in being a few hundred dollars off with a $2 Million asset balance for the company and several thousand dollars off. A few hundred dollars is not going to affect the decision models for management nor investors. A few thousand dollars will impact the financial position of the company.

This lesson will first introduce the accountant to the relationship between the income statement and the balance sheet in regards to depreciation. Next the concept of straight-line depreciation is explained as the primary principle of calculating depreciation. Once the underlying principles are understood, this lesson will cover the various life classes of assets and Modified Accelerated Cost Recovery System (MACRS) used by the Internal Revenue Service. Finally, I finish with an illustration of how a car or truck is depreciated for a business.

Prior to reading the rest of this lesson, I encourage the reader to read the following articles on this website:

Introduction to Depreciation (Lesson 50)
Depreciation – This is Weird Accounting
Accelerated Depreciation
Section 179
Depreciation Schedules (Lesson  51)
Book and Tax Depreciation (Lesson 52)

Depreciation – Balance Sheet and Income Statement Relationship

There is a relationship that exists between the balance sheet and the income statement. This relationship is similar to the economic reality of business. Assets are used (consumed) to make money. The perfect example is the sale of inventory. The debit value transferred to the income statement’s cost of sales decreases the credit generated for the sale with the end result of lower profit. At the same moment, the sale generates a newer bigger asset (hopefully cash) equal to the cost value of the inventory sold and the profit.

This same principle is used with fixed assets. When depreciation is recorded a debit is posted to the cost of sales and a credit is posted to accumulated depreciation. At the same moment the net profit on the income statement decreases because there are more debits (expenses) and over in the equity section of the balance sheet the current earnings decrease too. This assures that total assets (decrease due to depreciation) matches the similar decrease in equity. Look at this table for this simple relationship:

Balance Sheet                  Change           Income Statement           Change
Fixed Assets at Cost            –                     Revenue                             –            

(Accumulated Deprec)    Increases            Depreciation                   Increases 
Net Fixed Assets             Decreases          Total Expenses                Increases 
Equity                              Decreases          Net Profit                        Decreases

To clarify, here is a before and after balance sheet along with the income statement for ABC Company.

                                                        ABC COMPANY
                                               Comparative Balance Sheet
                                            Comparative Income Statement
                                            Month Ending October 31, 2016

                                         Before Depreciation              After Depreciation
Current Assets                         $12,500                                 $12,500
Fixed Assets at Cost                $76,200                                 $76,200
Accumulated Deprec.               (18,500)                                (20,250)
Net Fixed Assets                        57,700                                   55,950

Total Assets                             $70,200                                 $68,450

Liabilities                                  $30,000                                $30,000
Retained Earnings                    $27,600                                 $27,600
Current Earnings                        12,600                                   10,850
Sub-Total Equity                        40,200                                   38,450
Total Liabilities & Equity      $70,200                                 $68,450

Sales                                        $260,000                              $260,000
Cost of Sales                             180,600                                180,600
Gross Profit                               $79,400                               $79,400

Expenses                                     66,800                                  66,800
Depreciation                                                                              1,750
Net Profit                                  $12,600                               $10,850

The entry for the above is a simple debit of depreciation for $1,750 and credit accumulated depreciation for $1,750. Notice the changes to total assets and the effect on equity. This relationship is essential to understanding the impact of misestimating depreciation. Imagine calculating the depreciation as $2,750 instead of $1,750. The net fixed assets value $54,950 and the profit (current earnings) drops to $9,850. Now net profit is 3.8% of sales whereas before it was 4.2%. This is a 9.5% decrease in net profit for the company.  Estimating depreciation accurately is essential to fairly stating net profit and the value of assets on the balance sheet.

Straight-Line Depreciation

Mentally, a business entrepreneur thinks that a long-lived asset is used in equal amounts over its expected lifetime. Everyone assumes a piece of equipment will be utilized in equal amounts continuously. This may be true for some pieces of equipment. Think of an elevator, the number of riders that utilize this asset will pretty much be the same daily, monthly and yearly. Therefore its decrease in value will be straight-line over its lifetime. Let’s assume it will last 20 years before needing replacement and it costs 327,000 to build and install. Here is the depreciation table:

Elevator Cost:      $327,000

Periods  Deprec/Year      Deprec/Quarter      Deprec/Month
1               $16,350               $4,087.50                  $1,362.50

2                 16,350                 4,087.50                    1,362.50
3                 16,350                 4,087.50                    1,362.50
…               16,350                 4,087.50                    1,362.50
20               16,350                 4,087.50                    1,362.50
21                   –                      4,087.50                    1,362.50
…                    –                      4,087.50                    1,362.50
80                   –                      4,087.50                    1,362.50
81                   –                           –                            1,362.50
…                    –                           –                            1,362.50
240                 –                           –                            1,362.50
Total       $327,000               $327,000                   $327,000

This schedule simply calculates the depreciation used or assigned over the expected lifetime of the asset. In year 12, the asset’s total depreciation taken (accumulated depreciation) is $192,200 (12 * $16,350 or 48 quarters $4,082.50 or 144 months $1,362.5). The book balance in the asset section of the balance sheet looks like this:

Fixed Asset @ Cost                  $327,000         Debit Balance
Accumulated Depreciation      (192,200)         Contra Balance
Net Fixed Asset                       $130,000

The problem is that not all assets are like elevators where use is actually the same on a daily basis. Furthermore, the goal is to fairly state the asset’s fair market value on the balance sheet. You’ve heard the expression ‘Once you drive that car off the lot, it depreciates its value significantly’. Yet did the car really change that much in real value just because someone drives it one block? The answer is yes it does. Why? Because a buyer is willing to pay a premium for an unused car. Maybe the prior owner smoked and that smell is now in the fibers or maybe the seller thought he was a race car driver and loved to take the RPM’s to five and six thousand regularly. Just the simple fact that someone else owned it depreciates the value of the car.

What all this means is that an asset’s fair market value does not follow straight-line decreases in value. It is simply unrealistic. In reality, the value decreases at a faster rate in the early years and slows down in the later years. In accounting it is referred to as accelerated depreciation. The key is what is a reasonable estimate of this accelerated depreciation. To answer this, the accountant must first know how long of a life an asset will have.

Classes of Assets

All assets except land have some expected useful life. How long an asset will last is based on may factors including:

1) Utility                                       4) Conditions/Environment Where Used
2) Quality of Construction           5) Maintenance
3) Engineering                              6) Abuse

Fortunately there has been a long history involved with most common assets; therefore, there is some reasonably formulated expected life. The best source are the folks that receive information about assets and their respective utility every year. I’m referring to the IRS. In general the IRS breaks all assets out into nine classes (life expectancy groups).

The following are the respective nine groups and examples of the assets included. For a more detailed list, go to PUBLICATION 946 on the IRS website.

Three Year Assets

Any asset with an expected life of four or fewer years falls within this group. It includes:

* Race Horses                                      * Breeding Hogs
* Televisions                                        * Tractors (Long-Haul Transportation)
* Furniture  (Rentable Type)

Five Year Assets

* Automobiles                                      * Computers
* Light Duty Trucks                             * Office Equipment    (Copiers, Printers)
* Telephone Systems                            * Residential Appliances, Furniture & Carpet
* Research and Experimentation Equipment
* Beauty & Barbershop Equipment       * Taxis
* Contractor Tools                                 * Trailers (Long-Haul Transportation)

Seven Year Assets

* Office Equipment (non electrical) – Desks, Files, Furniture, Fixtures
* Electronic Communication Equipment – Cell Phones, Fax Machines
* Commercial Airliners                           * Fishing Boats
* Livestock                                              * Railroad Track
* Work Horses                                         * Farm Machinery & Equipment

Ten Year Assets

This group is for assets with an expected life between 16 and 20 years and includes:

* Marine Craft (Barges, Tugs, Vessels)
* Electric Grid Systems
* Fruit and Nut Bearing Trees/Vines
* Farm Fences

Fifteen Year. Assets

* Car Wash Buildings (The equipment inside is 7 year property)
* Billboards                                             * Service Station Structures
* Sidewalks/Curbs/Parking Lots             * Canals and Drainage
* Docks                                                    * Fences
* Playground Equipment

Twenty Year Assets

* Water Utility Systems                  * Customized Sheds/Garages
* Sewer Systems                             * Barns

Twenty-Five Year Assets

* Municipal Sewers
* Water Production Systems

27.5 Year Assets  (Real Estate Improvements)

* Residential Rental Property (Homes)    * Condos
* Manufactured Homes                            * Escalators

* Apartments                                            * Elevators

39 Year Assets

* Commercial Real Estate
* Manufacturing Facilities
* Office Buildings

The first seven of these classes of assets actually have a depreciation schedule that is accelerated early on in the asset’s life and levels out like straight-line depreciation in the later years. These schedules are courtesy of our friends at the IRS. The last two are real estate improvements (homes, offices and commercial property). Real estate improvements use straight-line depreciation throughout the entire expected useful life.

Modified Accelerated Cost Recovery System (MACRS)

For tax purposes, the Modified Accelerated Cost Recovery System (MACRS) is required for all tangible property. Because the IRS has already established the respective class lives, it in turn has estimated the depreciation for these class lives in accordance with a set of schedules. The depreciation is higher in the first few years and lower in the later years in comparison to the straight-line method. This reflects the fair market value reduction early on for simply driving the asset of the lot.

I encourage bookkeepers and accountants to use these estimated amounts from the tax schedule for book purposes. It makes the math simple and easy for estimation purposes. In addition, it is very difficult for an outsider or investor to challenge the formulas as either overestimating or underestimating depreciation for GAAP purposes. MACRS is a sound estimation of depreciation and widely accepted. Plus it is mandatory for tax purposes. This is especially appropriate in small business. 

The following is an overall table for the most popular six asset life groups.

General Depreciation Table
MACRS Based Percentages
Half-Year Convention (Mid-Month for Real Estate)

.                                                                                                               Real    Estate        
Recovery YR        3 YRS      5 YRS        7 YRS           10 YRS       27.5 YRS        39 YRS
1                             33.33        20.00          14.29             10.00           3.485               2.461

2                             44.45        32.00          24.49             18.00           3.636               2.564
3                             14.81        19.20          17.49             14.40           3.636               2.564
4                               7.41        11.52          12.49             11.52           3.636               2.564
5                                              11.52            8.93               9.22           3.636               2.564
6                                                5.76            8.92               7.37           3.636               2.564
7                                                                   8.93               6.55           3.636               2.564
8                                                                   4.46               6.55           3.636               2.564
9                                                                                         6.56           3.636               2.564
10                                                                                       6.55           3.636               2.564
11                                                                                       4.46           3.637               2.564
12                                                                                                         3.636               2.564
… (13 through 27)                                                                                3.636               2.564
28                                                                                                         1.970               2.564
29                                                                                                                                 2.564
…. (30 through 38)                                                                                                       2.564
39                                                                                                                                 2.564
40                                                                                                                                   .107

The term convention may be new to you. It simply means the starting point. The IRS simplified this by using the half-year model for tangible personal property. No matter when it was bought during the year, it is assumed to start on July 1 of that year. The first year of depreciation is always half of a full amount and the same goes for the final year. This is why a three-year asset is depreciated over four years. There are two halves (first and last) and the two full years in between totaling three years. A seven-year asset is depreciated over 8 years.

Real estate is done differently.  The land is non depreciable and is recorded separately from the structures (buildings). The building value is generally the tax ratio percentage as recorded for tax purposes. Here is a straight forward example:

The company buys a parcel of land with a warehouse on it for $1,295,000. The tax records indicate the land’s value at $275,000 and the structure worth $855,000. A ratio of structures (improvements) to the total is calculated as illustrated here:

Tax Basis            Value            Ratio
Land                 $275,000       24.34%

Improvements    855,000       75.66%
Total              $1,130,000     100.00%

The accountant simply multiples the improvements ratio by the actual purchase price to calculate the actual basis of improvements for depreciation purposes. This equals $979,845. The land component equals $315,155 ($1,295,000 –  $979,845).

Therefore, for depreciation purposes, this asset is calculated at 2.564% per year except in the year purchased and the final year (year 40). By the way, it equals $25,123 per year. Remember this is a commercial property and therefore is depreciated over 39 years plus one extra year associated with the convention concept explained above. Residential property is depreciated over 27.5 years as it is assumed to receive greater use associated with a family residing in the home continuously whereas commercial property is only exposed to use during business hours.

For more information on the amount to charge for depreciation in the first and last year of real estate, consult Publication 946 on the IRS website (IRS.GOV). If you have further questions, please consult with the company’s CPA for help.

Given all the above,  there is one asset scrutinized by the IRS that basically has its own set of rules.

Estimating Depreciation For Automobiles and Light Duty Trucks

In general, cars and light duty purpose trucks (gross vehicle weight < 6,000 pounds), which is the bulk of most vehicles, have a different set of depreciation rules. The issue pertains to the fact that most of these assets are used for both business and personal purposes. The typical taxpayer is not allowed to deduct his personal use of their family car and therefore the IRS doesn’t want the company to deduct the value associated with the personal use of a company vehicle. Basically, the IRS requires the company to have two depreciation schedules for these automobiles. One is the traditional MACRS schedule using the 5 year recovery period. The remaining basis of $14,495 is depreciated at $1,975 per year until all basis is utilized for depreciation.

Although this appears complicated, the IRS is trying to prevent abuse of depreciation with vehicles which it witnessed in the past. Heavy duty trucks and farm trucks are not luxury vehicles and therefore follow the standard MACRS depreciation schedule.

Summary – Estimating Depreciation

The tax rates and restrictions are actually more complicated than the above. However, you were not trained for the peculiar rules from the historical lessons for bookkeeping. The company’s CPA should address these intricate issues. Your job is to estimate the depreciation for fixed assets. The use of the MACRS tables is the perfect starting point. If you use your CPA wisely, get him/her to provide you with the depreciation schedules and the forecasted schedule for next year. Use this information to post depreciation to the books of record in the new year. Simply divide the amount provided by twelve and generate a recurring entry for monthly debits and credits.

Use the class lives and MACRS depreciation schedules for all new assets purchased by the business. Modify the recurring entry to reflect this change in debits and credits for depreciation. ACT ON KNOWLEDGE.

© 2018 – 2022, David J Hoare MSA. All rights reserved.

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