Fixed Assets

As we saw earlier, some assets are purchased for use in the business and expected to be used over multiple revenue periods (typically years). Cars, computer equipment, office furniture, etc., are all examples of Fixed Assets. In general, if you expect the asset to be in the business for a long period of time, it is likely a Fixed Asset.

Fixed Asset Costs

Fixed Assets tend to cost more and you pay an upfront cost to get benefits for multiple years. However, a drawback is that, if you record all of the costs when the asset is acquired, your profitability will drop in the year the asset is purchased (and will not be impacted in future years). This doesn’t adequately match revenues and expenses. Even when using the Cash Basis, you should still like to spread the cost of the fixed asset over all of the years it is used.

Depreciation

Depreciation is the process of spreading the cost of a fixed asset over the years of its useful life. You may use depreciation in both the Cash Basis and the accrual method. It allows for a more even treatment of the expense from the asset, with the revenue generated by using the asset.

There are generally four methods by which to depreciate assets. To calculate depreciation, regardless of method, you will need to know the following:

• Cost of the asset
• Estimated salvage value at the end of the asset’s life
• Number of years for which the asset will be used

Straight-line Depreciation

In Straight-line depreciation, we simply take the cost of the asset, subtract its salvage value, and divide the difference by the number of years for which the asset will be used. The formula is:

(Acquisition cost - Salvage value) ÷ Years of life = Annual depreciation

Note that acquisition cost can include delivery and setup expenses, although these expenses can also be recorded separately and deducted in the year they occurred.

Units of Production

Sometimes, it is possible to determine how many units a piece of equipment can produce, and the depreciation entry is accurately computed as the number of units produced for the given year, divided by the total number of units that can be produced. For some fixed assets, such as office furniture, computer systems, and cars, the Units of Production method does not make sense. However, in manufacturing or processing plants in which it is known how much production a machine can provide, this method provides an accurate depreciation method.

To compute the depreciation, you need two steps:

First, compute the per-unit cost of the machinery:

(Acquisition cost - Salvage value) ÷ Capacity in units = per-unit cost

Once you know the per-unit cost, determine how many units were produced that period:

Depreciation expense = Number of units * per-unit cost

As an example, let’s say we purchase a production machine to produce gasoline from crude oil. It is estimated that the machine can produce 750,000 gallons of gasoline and the machine cost (after salvage value) is $175,000. The per-unit capacity of that machine is 23 cents per gallon.

Assuming in the first year we produce 125,000 gallons of gasoline, our depreciation entry for the year is:

125,000   * .23333 = $29,166.25

This method allows for a close matching of the expense associated with the asset with the revenue produced by it.

Accelerated Depreciation

The Straight-line depreciation method does not account for the fact that, as an asset ages, it is typically less productive. This method assumes that the “deduction” should be uniform throughout the asset’s life. However, in many cases, an asset is more productive early on in its life so it might make sense to apply more depreciation in the early periods when more revenue is generated as a result of the asset. The Accelerated Depreciation methods attempt to do just that.

Declining Balance

One approach to Accelerated Depreciation is to compute the straight-line value for a period and then double it. The same formula is applied in subsequent periods; however, the formula is only applied to the remaining balance of the asset, not the original purchase cost.

To calculate the formula, we first have to determine the straight-line rate. Assuming an asset has an eight-year-long life, the straight-line rate is 12.5 percent (100 percent divided by eight years). We are going to double that rate so, each year, we will deduct 25 percent of the balance left on the asset.

Let’s say we have an asset that costs $37,000 and a $4,000 salvage value. Depreciation is eight years for this asset. The double declining calculation for the first year is:

•                     $37,000 * .25  = $9,250

To compute the second year, we use the following formula:

• $37,000 - $9,250 = $27,750 - Compute current book value
• $27,750 * .25  = $6,938

The third year’s calculation is:

• $37,000 - ($9,250 + $6,938) = $15,609 - Year three book value
• $15,609 * .25 = $5,203

This calculation is repeated until the remaining balance of the asset is less than the book value. In our example above, the seventh year has a book value of $4,939 and a depreciation value of $1,646. This means that, in the eighth year, the deprecation entry can only be $939—which reduces the value of the asset down to $4,000 (i.e., its salvage value).

When using this approach, there is not a definite number of periods. Sometimes you might hit the salvage prior to the eighth year and, at other times, you might hit it afterwards.

Sum of the Years Digits

The Sum of the Year’s Digits is another accelerated depreciation method that strives to take higher depreciation in the early years of an asset’s life and less depreciation as the asset gets older. It does this by creating a planned depreciation percent each year that decreases the asset value until the salvage value is met.

To calculate the amount of depreciation per year, you first need to take the number of years and add up the individual year’s digits. For example, if you have a four-year life, to compute the base you would add the years as shown below:

• 1 + 2 + 3  + 4 = 10

Or simpler:

• Years * (Years +1) / 2 = 4 * 5 = 20 / 2 = 10

No matter which formula you use, you’ll still get the base for the formula. For each year, you take the year number (starting backwards) and divide it by the base. So, the first year (counting backwards) is four. The depreciation percent for the first year is:

• 4/10 or 40 percent

The second year would be:

• 3/10 or 30 percent

Assuming an asset with a $15,000 value and $3,000 salvage value, the depreciation for each year would look like:

•                     Year    1          4/10     = 40 percent   = $4,800
•                     Year    2          3/10     = 30 percent   = $3,600
•                     Year    3          2/10     = 20 percent   = $2,400
•                     Year    4          1/10     = 10 percent   = $1,200

After the end of the fourth year, the total depreciation is $12,000 and the value of the asset is $3,000—which is its salvage value.

Depreciation Examples

To look at how depreciations work, let’s work through an example. Suppose we purchased a computer system consisting of network servers, workstations, and printers for the office. The entire system ran $27,000, and cost $1500 for shipping and set up work. We anticipate using the system for five years. Most likely, after five years, our five-year technology will not be useful (but let’s be hopeful and assume we can sell it for $1,000 to some collector on eBay).

• System Cost:                         $27,000
• Installation/Setup:                  $1,500
• Salvage Value:                       $1,000
• Estimated Life:                        Five years
• Declining Balance Rate           45 percent

We decide to include our installation cost in our depreciation calculations. So, our total acquisition cost of the asset is $28,500. The following table illustrates various depreciation methods:

Modified Accelerated Cost Recovery System (MACRS)

In the U.S., the IRS allows a system called MACRS to be used to calculate depreciation for tax purpose. MACRS stands for Modified Accelerated Cost Recovery System. It supports larger deductions in earlier years and lower deductions in later years. The MACRS system is based upon the Declining Balance Depreciation method we covered earlier. However, the IRS indicates how certain asset classes must be depreciated and the asset’s useful life span.

To depreciate an asset by using MACRS, the first step is to look up the asset class on the IRS form. For example, office furniture has a class life of 10 years, with a MACRS recovery period of seven years. Computer systems have a class life of six years, with a MACRS recovery period of five years.

Once you know the recovery period, you can chose one of three recovery percentages (100 percent, same as straight-line), 150 percent or 200 percent. With this information, you can take the depreciation deduction by using a declining balance method as described earlier. However, the calculation is more complex because the IRS also considers when the asset was acquired. So, in the first year, depreciation might be reduced for assets put in place later in the year.

Note: MACRS depreciation is more involved than the simple taste shown above. When depreciation is less than straight-line, straight-line may be used. Assets acquired midway through the year are handled differently. While the concept of declining balance is used, there are many more rules put into place by the IRS.

Summary

Assets are needed by the business, and spreading the cost of the asset over multiple periods more closely matches the cost with the revenue that will be produced by the asset. Depreciation methods are designed to provide as accurate of a cost/revenue match as possible. However, the IRS requires that the depreciation be consistently handled within its rules in order to prevent abuse of depreciation (by using different methods, useful life, etc.).