Bean counters: please explain “depreciation” to me

I’m taking a class called “Management of Engineering Systems.” We are currently learning about “cash flow” and “methods for computing depreciation.” Mystery words I’m encountering include MACRS, straight line, double declining, discount rate and VDB.

I’m an engineer, so by definition I’m a Total Moron[sup]TM[/sup] when it comes to anything financially related.

So someone tell me… what the hell is “depreciation” all about?

I found the following somewhere on the web:

Huh? I don’t get it. Why is there a tax benefit? If I plop down $50,000 for a machine, isn’t $50,000 my one-time expense?

Solid state physics seemed so much simpler… :rolleyes:

>> Huh? I don’t get it. Why is there a tax benefit? If I plop down $50,000 for a machine, isn’t $50,000 my one-time expense?

Nope. It is an asset now and the yearly depreciation is the expense. If you buy a car for $10,000 would you say you are nstantly $10000 poorer. No, you say you have $10000 in the ofrm of a car, and then, every year, you count as an expense the depreciation of the car until the car has been fully depreciated.

Oh, I fergot the tax part. Since taxes are levied on profits (not on raw gross income) and profits are affected by expenses and depreciation is an expense, how you depreciate makes a difference in what your profits are. You may prefer to have more expenses this year and fewer next year, or viceversa. That’s where creative accounting comes into play and that’s why the government issues rules on what you may and may not do and then it takes even more creativity to get around that.

A simple example: I may want to depreciate an asset over a very short time because that saves me taxes now. So the government says an asset of type X cannot be depreciated in less than 5 years. So I say fine, not to worry. A leasing company purchases that asset and leases it to me at a rate which pays for the asset in 3 years and then they say the asset is mone to keep for free. In fact what I have done is amortize the asset in 3 years where the law says I cannot do it in less than 5 years. And so on. Bean counters do a lot of things and counting beans is the least of what they do.

There are two sides to the depreciation story, depending on who you are reporting to.

If you are reporting to the IRS, you want to maximise depreciation so as to minimise tax. Expensing the item in the first year is the best outcome. Barring that, you want to depreciate over the shortest possible time and get the biggest deductions in the earliest years (i.e., use a declining value method).

If you are reporting to shareholders, you want to minimise depreciation so as to maximise apparent profit. In that case, you depreciate over the longest possible time and eliminate big deductions in the early years (i.e., use the straight line method).

You are correct - there is no tax benefit in depreciation. What the original quote meant was that the tax benefits that there are are spread over several years, not all in one year, which is what you get when an item is an expense.

The tax disadvantages of depreciation can be a real pain for small companies. Consider:

Income $500k
Costs: $500k, including a $100k asset purchase.

You broke even, right? No taxes. Wrong. If the asset is depreciated over 5 years, then for tax purposes your costs were $420k and you now have to find a way of paying the tax on $80k out of your non-existent profits.

As sailor said, you can improve this by leasing assets. My company gets all its PCs on 2 year leases, thereby a) paying over 2 years, and b) being able to expense all the payments each year.

Depreciation is the systematic charging of capital expenditure on an asset to the profit and loss account over several accounting periods. This is in recognition of the fact that the asset will contribute to income-generating activities in each period, not just the one in which it was bought. This is allied to the fundamental accounting concept of matching, ensuring that costs and revenues are matched to the periods and activities where they occurred.

The straight line method of depreciation is nice and simple, with a fixed amount charged each period until the asset has reached the end of its Useful Economic Life (UEL). The charge is calculated as (purchase cost less residual value) divided by UEL (in years or months). The residual value may be zero, or it may be greater than that if you have reason to believe you could sell the asset on once you’re finished with it.

Reducing balance depreciation is the main alternative, more appropriate for assets which generate more revenue in early years than in later years (e.g. as an asset’s efficiency decreases). This is calculated as a % depreciation rate multiplied by the asset’s Net Book Value (NBV). The NBV is the current value of the asset - e.g. it’s purchase cost less accumulated depreciation to date.

There’s also a machine hour method, where depreciation is calculated as ((purchase cost less residual value) divided by UEL (hours)) multiplied by actual use (hours).

Basically, it’s not primarily about tax at all. It’s about accounting for the value of an asset over that period where it’s actually providing value. It’s fairly similar to the requirement to account for accruals and prepayments separately.

There are also terms for the various types of accounting. “Cost accounting”, “management accounting” and “tax accounting” to name the most common. If Crusoe is an accountant, Crusoe is clearly a cost accountant.

Not an accountant; trained for two years but moved into systems security. Cost accounting was the fundamental training - management got skimmed over and tax accounting not covered at all!