Depreciation expense is an allowance for the wear and tear of using property in a trade or business. A company calculates its depreciation expense for book and tax purposes, often requiring different methods.
For example, a U.S. company’s internal accounting and depreciation methods may be prepared according to Generally Accepted Accounting Principles (GAAP), while its depreciation for U.S. federal tax purposes follow the laws under the Internal Revenue Code (IRC) and other guidance from the Internal Revenue Service (IRS).
Depreciation Expense for U.S. Federal Tax Purposes.
Under the IRC, depreciation expense is an annual income tax deduction that allows a business to recover the cost of property over its useful life. A company generally needs Property, Plant & Equipment (PPE) to operate its business, and most of these assets have finite useful lives, hence the depreciation expense.
For U.S. federal tax purposes, a taxpayer shall be allowed a depreciation deduction as a reasonable allowance for the exhaustion, wear, and tear of property used in the trade or business or property held for the production of income.1
A company can generally depreciate most tangible personal and real property used in a trade or business. For a company to depreciate its business property, the property generally must meet the following requirements:
- The property must be owned by the business
- The property must be used in a trade or business or an income-producing activity
- The property must have a determinable useful life
- The property must have an expected useful life of more than one year.
Different Depreciation Methods
There are various depreciation methods for book purposes under US GAAP and for federal income tax reporting purposes. Not all methods apply to each authority.
Popular U.S. GAAP depreciation methods include the following:
- Straight-line depreciation method
- Declining Balance Method
- Double Declining Balance Method
- Sum of the Years Digits Method
- Units of Production Method
Popular U.S. federal tax depreciation methods include the following:
- Straight-line depreciation method
- Modified Accelerated Cost Recovery System (MACRS)
- Accelerated Cost Recovery System (ACRS)
- Special Depreciation Allowance (i.e., Bonus Depreciation)
- Section 179 Deduction
Example of Book Depreciation Expense Under US GAAP
Company Delta buys a piece of machinery equipment for $50,000 with a useful life of 7 years. It expects the salvage value to be $11,500 at the end of 7 years. The company will depreciate the asset using the straight-line method.
The company calculates its yearly depreciation expense (DE) as follows:
DE = (Purchase Price – Salvage Value) / Useful Life in Years
DE = ($50,000 – $11,500) / 7
DE = $5,500 per year
After seven years of depreciation expense, the company depreciates the asset to its salvage value of $11,500. Straight-line depreciation is not an accelerated depreciation method because because the amount of depreciation expense is not greater for the earlier years – it is equal on a year-to-year basis.
Other Information
More information about depreciation methods and rates for U.S. federal tax purposes can be found at the IRS website inside IRS Publication 946 (How to Depreciate Property).