# What Is the Tax Impact of Calculating Depreciation?

## What Is the Tax Impact of Calculating Depreciation?

Depreciation is a way of allocating the cost of tangible or fixed assets over the useful life of the item. In other words, a percentage of the cost is allocated to times when the physical assets contributed to revenue or sales. Depreciation decreases the amount of taxes a corporation or organization pays via tax deductions by documenting the reduction in the value of an asset or assets.

Depreciation expenditure decreases the amount of profits on which taxes are calculated, lowering the amount of taxes owing. The greater the depreciation expenditure, the smaller the taxable income and, thus, the lower the tax obligation. The lower the depreciation expenditure, the larger the taxable income and the greater the tax liability.

### Key Takeaways

- Depreciation is a mechanism of allocating a percentage of an asset’s cost to times when the physical assets contributed to revenue generation.
- The amount of taxable profits reduced by a company’s depreciation expenditure decreases the amount of taxes owing.
- There are many ways for computing depreciation, including straight line basis, decreasing balance, double declining, units of output, and sum-of-the-years’digits, each with its own set of benefits and drawbacks.

## Understanding the Tax Impact of Calculating Depreciation

Depreciation is shown on the income statement as depreciation costs and is recognized after all revenue, cost of goods sold (COGS), and operating expenses have been shown, but before profits before interest and taxes, or EBIT, which is used to determine a company’s tax burden.

The entire amount of depreciation expenditure is recorded on a company’s balance sheet as cumulative depreciation and is deducted from the gross value of fixed assets reported. As monthly depreciation charges are levied against a company’s assets, the amount of cumulative depreciation grows over time.

When assets are retired or sold, the cumulative depreciation value on a company’s balance sheet is reversed, and the assets are removed from the financial statements.

## Ways to Calculate Depreciation

There are many ways for calculating depreciation:

Each approach recognizes depreciation expenditure in a different way, which alters the amount by which depreciation expense decreases a company’s taxable profits and hence its taxes.

### Straight Line Basis

Straight-line basis, often known as straight-line depreciation, is a method of depreciating a fixed asset throughout its estimated life. To utilize the straight-line technique, taxpayers must know the item’s cost, projected useful life, and salvage value; the amount an asset is expected to sell for at the end of its useful life.

For example, imagine business A spends $50,000 on a manufacturing equipment with a five-year projected useful life and a $5,000 salvage value. The annual depreciation expenditure for the manufacturing equipment is $9,000, or ($50,000 – $5,000).

### Declining Balance

The falling balance technique uses a greater depreciation rate in the early years of an asset’s useful life. It needs taxpayers to understand the asset’s cost, anticipated usable life, salvage value, and depreciation rate.

Assume Company B purchases a fixed asset with a useful life of three years; the cost of the fixed asset is $5,000; the depreciation rate is 50%; and the salvage value is $1,000.

Use the following formula to calculate the depreciation value for the first year: (net book value – salvage value) x (depreciation rate).Year one depreciation is $2,000 ([$5000 – $1000] x 0.5). The depreciation in year two is $1,000 ([$5000 – $2000 – $1000] x 0.5).

The depreciation for the last year of useful life is determined in the final year using the following formula: (net book value at the start of year three) – (estimated salvage value).In this scenario, the final year depreciation expenditure is $1,000.

### Sum-of-the-Years’ Digits

The sum-of-the-years’digits technique of accelerated depreciation calculates a percentage by adding the years of an asset’s useful life.

For example, business B spends $10,000 on a manufacturing equipment with a useful life of five years and a salvage value of $1,000. To determine the depreciation amount each year, first add the digits of the years. It is 15 years in this scenario, or (1 + 2 + 3 + 4 + 5). The amount depreciable is $9,000 ($10,000 – $1,000).

Because there are five years remaining in the usable life, the multiplier in the first year is 5 15; in the second year, it is 4 15; in the third year, it is 3 15; and so on. Depreciation is worth $3,000 ([$10,000 – $1,000] x [(5 15]). Use this approach until the salvage value is reached.

## IRS and Depreciation

According to the Internal Revenue Service (IRS), “If you depreciated property before 1987, you must utilize the Accelerated Cost Recovery System (ACRS) or the method you previously employed. The Modified Accelerated Cost Recovery System (MACRS) is normally required for property put in operation after 1986.”

Publication 946 of the IRS contains guidelines on how to depreciate property.

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