What Is the Tax Impact of Calculating Depreciation? (2024)

Depreciation is an accounting method used to calculate decreases in the value of a company’s tangible assets or fixed assets. By charting the decrease in the value of an asset (or assets) over time, depreciation reduces the amount of taxes a company or business pays through tax deductions

Tax deductions reduce the amount of earnings on which taxes are based (by reducing the value of these assets on a company's income statement), 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.

Depreciation on an Income Statement

Indicated as depreciation expenses on a company's 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 (EBIT), which is ultimately used to calculate a company's tax expense.

The total amount of depreciation expenses are recognized as accumulated depreciation on a company's balance sheet and is subtracted 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 its financial statements.

Methods for Calculating Depreciation

There are four methods used for calculating depreciation: Straight line basis (straight line depreciation), declining balance, units of production, and 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

Straight-line basis, or straight-line depreciation, depreciates a fixed asset over its expected life. 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 per year (($50,000 - $5,000) ÷ 5).

Declining Balance

The declining balance method applies a higher depreciation rate 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 that 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 this 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.

Units of Production

Theunits of production methodassignsan equal expense rate to each unit produced. This method is most useful when an asset's value lies in the number of units it produces—or in how much it's used—rather than in its lifespan. The formula determines the expense for theaccounting periodmultiplied by the number of units produced.

For example, suppose company B buys a fixed asset for $25,000. The salvage value is $500. It's estimated to produce 50,000 units over its life; it produced 5,000 units this year.

To find the depreciation value, use this formula: (asset cost - salvage value)/estimated units over asset's life x actual units made. The depreciation for the accounting period is $2,450 (($25,000 - 500)/50,000 x 5,000 = $2,450.

This method will produce results that vary annually depending on the number of units made.

Sum-of-the-Years' Digits

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. It has a useful life of five years and a salvage value of $1,000. 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.

The Bottom Line

Depreciation reduces the value of assets, such as real estate and machinery, on a company's balance sheet. As a result, the amount of earnings on which taxes are based is reduced. While there are multiple accounting methods for determining depreciation, thesemethods are typically industry-specific. The four depreciation methods include straight-line, declining balance, sum-of-the-years' digits, and units of production.