Accounting: The Language of Business (Part 60)

“And God said to accountants: Go forth and multiply.” —Unknown

 Fixed Assets and Intangible Assets (Part D)

by

Charles Lamson

Depreciation for Federal Income Tax

The Internal Revenue code specifies the Modified Accelerated Cost Recovery System (MACRS) for use by businesses in computing depreciation for tax purposes. MACRS specifies 8 classes of useful life and depreciation rates for each class. The two most common classes, other than real estate, are the 5-year class and the 7-year class. The 5-Year class includes automobiles and light-duty trucks, and the 7-year class includes most machinery and equipment. The depreciation deduction for these two classes is similar to that computed using the declining-balance method discussed in part 59.

In using the MACRS rate, residual value is ignored, and all fixed assets are assumed to be put in and taken out of service in the middle of the year. For the 5-year class assets, depreciation is spread over six years, as shown in the following MACRS schedule of depreciation rates:

To simplify its record-keeping, the business will sometimes use the MACRS method for both financial statement and tax purposes. This is acceptable if MACRS does not result in significantly different amounts than would have been reported using one of the three depreciation methods discussed in parts 58 and 59.

Using MACRS for both financial statement and tax purposes may, however, hurt a business. In one case, a business that had used MACRS depreciation for its financial statements lost a $1 million order because its fixed assets had low book values. The bank viewed these low book values as inadequate, so it would not loan the business the amount needed to produce the order.

Revising Depreciation Estimates

Revising the estimates of the residual value and the useful life is normal. When these estimates are revised, they are used to determine the depreciation expense in future periods. They do not affect the amount of depreciation expense recorded in earlier years.

To illustrate, assume that a fixed asset purchased for $130,000 was originally estimated to have a useful life of 30 years and a residual value of $10,000. The asset has been depreciated at $4,000 per year [($130,000 - $10,000) / 30 years] for 10 years by the straight-line method. At the end of 10 years, the asset's book value (undepreciated cost) is $90,000, determined as follows:

During the eleventh year, it is estimated that the remaining useful life is 25 years (instead of 20) and thus the residual value is $5,000 (instead of $10,000). The depreciation expense for each of the remaining 25 years is $3,400, computed as follows:

Composite-Rate Method

Assets may be grouped according to common traits, such as similar useful lives. For example a group might include all delivery trucks with useful lives of less then 8 years. Likewise, a group might include all office equipment or all store fixtures. Depreciation may be determined for each group of assets, using a single composite rate, rather than a rate for each individual asset. The depreciation computations are similar for groups of assets as for individual assets. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 400-402*

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