Depreciation Expense: What is it & Does it Impact Financial Statements

The declining balance method is an accelerated depreciation expense approach where higher expenses are recorded in the earlier years of an asset’s life. This reflects the reality that many assets lose value faster in their initial years of use, such as vehicles or electronics.

Formula for Declining Balance:

Book Value at Beginning of Year × Depreciation Rate

When you calculate depreciation expense with this method, it is particularly useful for tax purposes, as it allows businesses to claim higher deductions upfront.

This method ties depreciation to the asset’s usage, making it ideal for machinery or equipment where wear and tear depend on output or operational hours. Depreciation is calculated based on the asset’s total expected production or usage.

Formula for Units of Production

(Cost of Asset – Salvage Value) ÷ Total Estimated Units × Units Used During the Period

Example: A $15,000 machine expected to produce 100,000 units would have a depreciation expense of $0.15 per unit. If 20,000 units are produced in a year, the depreciation expense would be $3,000.Businesses use different depreciation methods to allocate the cost of assets based on their usage and financial strategies.

The SYD method is another accelerated approach that assigns higher depreciation expenses in the early years. It uses a fraction-based system to determine expense allocation. The numerator is the remaining life of the asset, and the denominator is the sum of the years of the asset’s useful life.

Formula for Sum-of-the-Years-Digits

(Remaining Life ÷ Sum of the Years) × (Cost of Asset – Salvage Value)

Example: If an asset has a 5-year life, the sum of the years is 1 + 2 + 3 + 4 + 5 = 15. The expense for the first year would be 5/15 of the depreciable cost.Types of Depreciation Expense Methods

On the balance sheet, depreciation affects the value of assets through an account called accumulated depreciation, which represents the total depreciation expense recorded over time. This reduces the book value (or net carrying amount) of the asset.

Key Effects on Balance Sheets

• Decreases the total value of long-term assets.
• Accumulated depreciation grows over the asset’s useful life, reducing the asset’s net book value.
• Provides a clearer picture of an asset’s current worth, accounting for wear and tear or obsolescence.

Example of a Balance Sheet Calculation: A machine purchased for $50,000 with $30,000 in accumulated depreciation will have a book value of $20,000 on the balance sheet.

Depreciation appears in the operating activities section of the cash flow statement as a non-cash adjustment. Since depreciation expense is subtracted to calculate net income but doesn’t involve actual cash outflows, it is added back to reconcile net income with cash flow from operations.

Key Effects on Cash Flow Statements

• Increases cash flow from operations by offsetting non-cash expenses.
• Provides a clearer picture of the business’s cash-generating capability.

Example of a Cash Flow Statement Calculation: If net income is $50,000 and depreciation expense is $10,000, cash flow from operations will include an adjustment adding back $10,000, resulting in a higher operating cash flow.

Depreciation is considered a non-cash expense, but it’s treated as a legitimate deduction for tax purposes. By lowering taxable income, businesses can reduce their overall tax liability without impacting cash flow.

Example: If a business earns $100,000 in revenue but claims $20,000 in depreciation, it will only pay taxes on $80,000 of taxable income.

The IRS provides guidelines for calculating depreciation expense, including the types of assets eligible for depreciation and the methods allowed. In the U.S., the Modified Accelerated Cost Recovery System (MACRS) is commonly used for tax purposes.

Key Features of MACRS Depreciation Deduction

• Allows for accelerated depreciation, offering larger deductions in the early years of an asset’s life.
• Categorizes assets into property classes (such as 3, 5, 7, or 39 years) based on their expected useful life.

Note: Businesses must follow IRS rules for selecting depreciation methods and property classes to ensure compliance and avoid penalties.

In addition to traditional depreciation, the Section 179 deduction allows businesses to immediately expense the full cost of qualifying assets in the year they are placed in service.

Key Points of Section 179 Deduction

• Limits on total deductions may apply (e.g. $1.16 million in 2023).
• Only applicable to certain assets, such as equipment, machinery, and off-the-shelf software.
• Provides significant tax savings by accelerating deductions.

Businesses can also take advantage of bonus depreciation, which allows for a larger percentage of an asset’s cost to be deducted upfront.

Key Features of Bonus Depreciation Expense

• As of recent legislation, 100% bonus depreciation is allowed for qualifying assets (subject to phase-out schedules).
• Often used alongside MACRS or Section 179 deductions for maximum tax benefits.

To claim depreciation deductions, businesses must maintain detailed records of asset purchases, including:

• Purchase price and date.
• Asset classification and useful life.
• Depreciation method used.

Proper documentation ensures accurate tax reporting and compliance with IRS regulations during audits.

Depreciation can significantly influence tax planning by:

• Allowing businesses to defer taxes through accelerated deductions.
• Supporting reinvestment by freeing up cash flow.
• Helping businesses manage taxable income in high-revenue years.