What is the tax impact of calculating depreciation?

Depreciation is a method used to allocate the cost of tangible assets or fixed assets over the assets' useful life. In other words, it allocates a portion of that cost to periods in which the tangible assets helped generate revenues or sales. By charting the decrease in the value of an asset or assets, depreciation reduces the amount of taxes a company or business pays via tax deductions.

A company's depreciation expense reduces the amount of earnings on which taxes are based, thus reducing the amount of taxes owed. The larger the depreciation expense, the lower the taxable income and the lower a company's tax bill. The smaller the depreciation expense, the higher the taxable income and the higher the tax payments owed.

Indicated in the form of depreciation expenses on the income statement, depreciation is recognized after all revenue, cost of goods sold (COGS) and operating expenses have been indicated, and before earnings before interest and taxes, or EBIT, which is ultimately used to calculate a company's tax expense.

The total amount of depreciation expense is recognized as accumulated depreciation on a company's balance sheet and subtracts from the gross amount of fixed assets reported. The amount of accumulated depreciation increases over time as monthly depreciation expenses are charged against a company's assets. When the assets are eventually retired or sold, the accumulated depreciation amount on a company's balance sheet is reversed, removing the assets from the financial statements.

There are a few different methods to calculate depreciation:

• straight line basis (straight line depreciation)
• declining balance
• double declining
• units of production
• sum-of-the-years’ digits

Each method recognizes depreciation expense differently, which changes the amount in which the depreciation expense reduces a company's taxable earnings, and therefore its taxes.

Straight-line basis, or straight-line depreciation, depreciates a fixed asset over its expected life. In order to use the straight-line method, taxpayers must know the cost of the asset being depreciated, its expected useful life and its salvage value – the price an asset is expected to sell for at the end of its useful life.

For example, suppose company A buys a production machine for $50,000, the expected useful life is five years and the salvage value is $5,000. The depreciation expense for the production machine is $9,000, or $50,000 - $5,000 ÷ 5, per year.

The declining balance method applies a depreciation rate that is higher in the earlier years of the useful life of an asset. It requires that taxpayers know the cost of the asset, its expected useful life, its salvage value and the rate of depreciation.

For example, suppose company B buys a fixed asset has a useful life of three years, the cost of the fixed asset is $5,000, the rate of depreciation is 50% and the salvage value is $1,000.

To find the depreciation value for the first year, use the following formula: (net book value - salvage value) x (depreciation rate). The depreciation for year one is $2,000 ($5000 - $1000 x 0.5). In year two, the depreciation is $1,000 ($5000 - $2000 - $1000 x 0.5).

In the final year, the depreciation for the last year of the useful life is calculated with this formula: (net book value at the start of year three) - (estimated salvage value). In this case, the depreciation expense is $1,000 in the final year.

The sum-of-the-years’ digits is an accelerated depreciation method where a percentage is found using the sum of the years of an asset’s useful life.

For example, company B buys a production machine for $10,000 with a useful life of five years and salvage value of $1,000. In order to calculate the depreciation value per year, first calculate the sum of the years' digits. In this case, it is 15 years, or (1+ 2 + 3 + 4 + 5). The depreciable amount is $9,000 ($10,000 - $1,000).

In the first year, the multiplier is 5 ÷ 15, since there are five years left in the useful life; in the second year, the multiplier is 4 ÷ 15; in the third year, the multiplier is 3 ÷ 15; and so on. The depreciation value is $3,000 ([$10,000 - $1,000] x [(5 ÷ 15]). Use this method up until the salvage value.