Most of the startup financial models that I built here on the site have depreciation factored in. I generally build logic for straight-line methodology only, but when you get deep down into the nuance and Accounting for depreciation, things get wild.
Depreciation is an important accounting concept that refers to the process of allocating the cost of a long-term asset over its useful life. Here are some interesting accounting concepts regarding depreciation:
- Straight-Line Depreciation: This is the most common method of depreciation, where the cost of the asset is evenly spread out over its useful life. For example, if a company purchases a machine for $10,000 with a useful life of 5 years, the annual depreciation expense would be $2,000 ($10,000 / 5 years).
- Accelerated Depreciation: This method of depreciation allows a company to allocate a greater portion of the asset's cost to the earlier years of its useful life, resulting in higher depreciation expenses in the earlier years and lower expenses in the later years. This can be advantageous for tax purposes, as it allows a company to take a larger tax deduction in the early years. You may like the ability to invest more of the profits (if there are any) into building the business during the early years instead of paying taxes.
- Depreciation Recapture: When a company sells a long-term asset that has been depreciated, it may be required to recapture some of the depreciation that has been taken. This means that the company must pay taxes on the difference between the selling price of the asset and its adjusted basis (the cost of the asset minus the total amount of depreciation taken). Note, in a real estate transaction, there are even more complications. If the property used straight line depreciation, then the depreciation recapture is not taxed at ordinary income tax rates and instead would fit into the more favorable tax rate (section 1250 gains).
- Salvage Value: This is the estimated value of an asset at the end of its useful life, which can be used to reduce the amount of depreciation taken over the asset's useful life. For example, if a company expects to sell a machine for $2,000 at the end of its 5-year useful life, the salvage value would be subtracted from the cost of the machine ($10,000 - $2,000 = $8,000), and depreciation would be calculated based on the net cost of $8,000.
- Depreciation Expense vs. Accumulated Depreciation: Depreciation expense is the amount of depreciation that is recognized as an expense on the income statement each year, while accumulated depreciation is the total amount of depreciation that has been recognized over the life of the asset. The difference between the two is the book value of the asset, which represents its remaining value on the company's balance sheet. I include this on nearly every financial forecasting model.
More on Depreciation Recapture
Let's say that a company purchased a machine for $100,000 five years ago and has been depreciating it using the straight-line method over a useful life of 10 years. This means that the company has taken $50,000 in depreciation expense over the past five years ($100,000 cost / 10-year useful life x 5 years).
Now, let's say that the company decides to sell the machine for $80,000. The company must calculate its gain or loss on the sale of the machine by subtracting the adjusted basis of the asset (the original cost minus the total depreciation taken) from the selling price.
Adjusted basis = Original cost - Total depreciation taken
Adjusted basis = $100,000 - $50,000
Adjusted basis = $50,000
Gain on sale = Selling price - Adjusted basis
Gain on sale = $80,000 - $50,000
Gain on sale = $30,000
In this case, the company has a gain of $30,000 on the sale of the machine. However, because the company has already taken $50,000 in depreciation expense on the machine, it must recapture a portion of that depreciation as ordinary income. The amount of depreciation recapture is equal to the lesser of the gain on the sale or the total amount of depreciation taken.
In this case, the company must recapture $30,000 in depreciation, which is the amount of the gain on the sale. The company will pay taxes on this $30,000 as ordinary income, rather than at the capital gains rate, which is typically lower. The remaining $20,000 from the sale of the machine is treated as a capital gain, which may be subject to a lower tax rate.
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Article found in Accounting and Finance.
