Teach me about depreciation

Factual Questions
1

OK, here’s what I know: if my company buys, let’s say, furniture, I don’t count its value as an asset the same every year. This is obvious: when it’s new, I might be able to say it’s worth what I paid for it. But ten years later, it’s ten-year-old furniture. And not worth much.

So I figure of what the residual value of the furniture is, and the difference between that and the new value. That difference is what gets subtracted over the depreciation period. So if my new furniture costs $12,000 and will be worth $2,000 in five years, and assuming I use five years for furniture, then I can say that at the end of the first year, its value is $10,000; at the end of the second year, $8,000; and so on. Right?

Now… how about real property? Say my company buys land and a building. It may go up in value. But those assets are “depreciated” as well.

Why?

2

I should know this stuff having worked in RE for most of my career. But I am not an accountant so as soon as I post this, a doper accountant will come beat me with a stick.

First, you don’t depreciate land. Unless you’re in Vegas and then you should write it down to zero as soon as possible.

For the improvements, if the property is consolidated on the balance sheet (as opposed to owning in a joint venture and therefore accounting under the equity method), you don’t mark the property to market. You take a gain or loss at sale. The only “profit” on the property is accounting income that the property generates.

The property is depreciated because in theory it will wear out. And I suppose if you didn’t make any capex investment over 39 years, the property may very well wear out, leaving you with little more than land value. As you invest capex you add that back into your accounting basis.

If you are a limited partner in a JV, you don’t take depreciation. But you do take mark to market gains and losses on your equity investment.

3

Depreciation is done by a set of rules that are either the law or the rules of “Generally Accepted Accounting Practices” (GAAP). Accounting for depreciation need not bear any direct relation to the market value of the asset and typically doesn’t. For example, a building may be depreciated to zero, while its market value goes up. Different categories of assets are depreciated over different amounts of time. Companies have some latitude in how they do the depreciation and often do “accelerated depreciation” in which depreciation happens faster in the earlier years. A common method is the “sum of the digits” schedule. For example if you are depreciating over 5 years, you add the numbers 1 to 5 to get 15, then depreciate 5/15 the first year, 4/15 the second year and so forth, with 1/15 in the last year.

None of this has ever made any real sense to me, but the rules have to be followed. The company shows a lower profit, since the depreciation is considered a loss. This is bad for profits in the depreciation years, but otherwise you would take a big hit when you spent the money on the asset in the first place.

4

If you are talking about depreciation for US federal income tax purposes, then there are (a lot of) rules on how exactly each type of asset is depreciated. And many are not as simple as you have illustrated (but to the taxpayer’s benefit–i.e., you can typically depreciate your full basis down to zero (so no salvage value as in your illustration), and assets other than real property are depreciated using methods that front-load depreciation (i.e., the double-declining balance method v. the straight line method that you have illustrated)).

5

As an accounting concept, depreciation does not really have anything to do with the decline in market value of a fixed asset over its lifespan. Rather it is a form of cost allocation. The basis for it is the “matching principle”, which says that expenses should be matched to the time the corresponding revenues are generated.

Let’s say a business buys a truck that it expects to use to make deliveries for five years for a cost of $110,000, with an expected salvage value after five years of $10,000.

Now, the reason that the business bought the truck is because it thought that having the truck would help the business make money, perhaps by making its own deliveries rather than paying a shipping company because it is helping the company avoid shipping company expenses. Somehow, the net $100,000 the truck will cost the company over the five years should be matched to the additional revenue (or other avoided expenses) that it is generating.

Depreciation is the method that the net cost of a fixed asset is spread over the time period that the asset is helping to generate net profits. For the truck, the most straightforward way is to simply allocate the $100,000 net cost evenly over the five years, at $20,000 per year. Depending on the circumstances, there are other methods that can be used as well.

But the key thing is that depreciation is a measure of cost allocation over the period of a fixed asset’s useful life.

For land and a building, the portion of the purchase price attributable to the land is not subject to depreciation because land is considered to have an infinite useful life (unless it is used for something like mineral extraction, in which it must be depreciated based on the minerals removed against the total reserves). For a building, they are usually considered to have a long useful life, often something like 40 years. Although a building may last well more than 40 years, over that lifespan the building systems will have to be replaced and updated, making that a fair lifespan for depreciation purposes.

Hope this helps.

6

Billdo has got it right. The idea of depreciation being linked to a decrease in market value is a coincidence.

To illustrate the matching principle, let’s revisit the truck idea, assuming that the truck will be used to make $50,000 in revenue each year and that there are no other expenses.

If you do the books on purely a cash-in, cash-out basis, then buying a truck would make your books look like this:
Year 1: -60,000 ($50,000 revenue less $110,000 for the truck).
Year 2: 50,000
Year 3: 50,000
Year 4: 50,000
Year 5: 50,000

It raises the obvious question: what did the business managers do to screw up so badly in year 1? And how did they fix it so quickly? Obviously, they didn’t screw up - they knew that buying a truck would produce income over several years. The matching principle is designed to show how a one-time cost relates to 5 years of revenue.

Using depreciation to match the expense to revenue, the books look like this:
Year 1: 30,000 (50,000 revenue less 20,000 depreciation)
Year 2: 30,000
Year 3: 30,000
Year 4: 30,000
Year 5: 30,000

Now it’s clear from the financial statements that the managers didn’t screw up in the first year and that the truck’s earning potential is approximately the same each year.

Finally, it’s worth pointing out that depreciation, like many accounting concepts, is based on approximations. Sometimes those approximations are mandated by accounting policy or law (like a 39-year commercial building life span), but a lot of what goes into a financial statement involves approximation, estimation and extrapolation. That’s why you have to read the disclosures. Two accountants given the same situation will not come up with exactly the same numbers because they can use slightly different assumptions or estimations.

7

Damn. This is the post I wish I had written (insofar as it discusses the incorporeal concept of depreciation as a whole–I did alright on tax depreciation all by its lonesome). Nice job, sir.

8

I owned property that I rented. Each year, I showed an expense on my taxes related to depreciation of the property. The depreciation included both the building and the land. This reduced the “book value” of the property, or my cost basis. When I finally sold the property, I had to pay taxes on my gain, which was the sale price minus the book value (not what I actually paid for it). So even though I could deduct depreciation as an expense each year, I was taxed on those same dollars upon sale.

9

Reiterating several above posts:
Accounting wants to give you an accurate picture of finances…

So depreciation is taking the cost of an asset that makes money, and spreading it over several years that it makes money - until it finally wears out. The example of a $10,000 truck being used for 5 years and therefore being a $2,000 additional yearly cost of producing whatever the truck helps produce.

If the market is rational, depreciated cost (i.e. $8,000 after the first year) should match roughly what the asset is also worth. So when your books say you have an asset worth $8,000 that should give anyone looking at your books a good idea what the company is worth if you had to sell everything tomorrow at market price.

The gevernment likes to mess with depreciation rules (write things off faster, i.e.) to encourage businesses to re-purchase these assets more often, and encourage more business; plus a bigger write-off means a bigger tax break each year. However, if you seel the asset for more than it’s write-down value, that is extra profit to be taxed…

AFAIK, but IANAA, land does not depreciate. The buildings, like the truck, however do - as anyone who has seen a building in a bad state of repair can tell. Any major repairs - to a truck or a building - are capital improvements and increase the asset value, changing the write-down amount over the next few years; i.e. new tires or brake pads or painting the building are probably routine maintenance, but an engine rebuild or a major foundation repair is a capital improvement of the asset. This is an area where accountant advice (like legal advice) is critical when the numbers are large…

Assets are typically carried on the books at the purchase price. This is interesting for something like land; unless your major business is buying and selling land, the whole process of say, Safeway or Sears or Chase Manhattan owning land is simple - it’s on the books at purchase price. What’s trhe alternative - you would need to go out and get a valuation every year, with an event like last year the book value of the company would bounce up and down like a yoyo. Simper to just use the pruchase price. Unfortunately, this GAAP principle was based on the earlier 1900’s notion that prices did not fluctuate much. Companies like Greyhound were taken over on the basis that prime downtown land like bus terminals was still on the books in the 1980’s at 1940’s land prices and nobody really knew how much more valuable the company was. (A&P was the same, IIRC)

10

If you took a depreciation deduction for land on your tax return, you did so in error. Since you have subsequently sold the property and recognized a capital gain on the sale.

If your ordinary income tax rate (the tax benefit for the deduction) was greater than your capital gains tax rate (the tax expense for the gain on sale) then you technically owe the government for difference in the tax rates times the amount of depreciation you took on the land.

Hope you don’t get audited.