What Is the Tax Impact of Calculating Depreciation?

Depreciation is an annual income tax deduction that reduces the amount of taxes a company pays. As an accounting technique, depreciation allows corporations to recover the cost of certain assets over their useful life by charting the decrease in the value of a company’s tangible or fixed assets over time. Depreciation expense is the portion of the cost of an asset that has been depreciated for a single period, reflecting how much of its value was used up in that time. Depreciation expense appears on a company’s income statement as a non-cash expense that reduces the company’s net income.

For tax purposes, companies can treat depreciation expenses as tax deductions. By reducing the amount of earnings on which taxes are based (by reducing the value of these assets on a company’s income statement), depreciation reduces the amount of taxes owed. The larger the depreciation expense is, the lower the taxable income will be—and the lower a company’s tax bill will be, as a result. The smaller the depreciation expense, the higher the taxable income—and the higher the tax payments owed.

Depreciation can only be applied to tangible or fixed assets; tangible assets are any assets that have a physical form, including inventory, vehicles, furniture, or equipment. Fixed assets are a type of tangible asset; they are used for a long period in a company’s operations, such as buildings and land.

Key Takeaways

• Depreciation is an accounting method used to calculate decreases in the value of a company’s tangible assets or fixed assets.
• A company’s depreciation expense reduces the amount of taxable earnings, thus reducing the taxes owed.
• Several methods of calculating depreciation can be used, including straight-line basis, declining balance, double declining, units of production, and sum-of-the-years’ digits, all with different advantages and disadvantages.

Depreciation on an Income Statement

Depreciation expenses can be found on a company’s income statement. It 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 is 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 (also called straight line depreciation), declining balance, units of production, and sum-of-the-years’ digits.

Each method recognizes depreciation expenses differently, which changes the amount by which the depreciation expense reduces a company’s taxable earnings—and, therefore, its taxes.

Straight Line Basis

Straight-line basis (also called straight-line depreciation) depreciates a fixed asset over its expected life. To use the straight-line method, a company must first identify the cost of the asset being depreciated, its expected useful life, and its salvage value. (Salvage value is 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. To use the declining balance method, a company must first identify 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 with 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

The units of production method assigns an 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.

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 the 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, which means it assumes that an asset will lose most of its value in the first few years of use.

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.

Does Depreciation Increase Taxable Income?

No, depreciation decreases taxable income because it allows businesses to include depreciation as an expense on their income tax return in a given reporting period, thereby decreasing their net income—and reducing their taxable income. Depreciation allows businesses to recover some of the costs of investing in certain type of assets. 

How Does Depreciation Affect the Tax Basis of an Asset?

Knowing an asset’s tax basis is the first step in calculating depreciation. An asset’s basis (for tax purposes) is generally its cost (with some additions or subtractions based on how the asset was acquired). Taxpayers can decrease an asset’s basis via allowable depreciation. A company’s total tax basis can decrease by the amount of depreciation deductions they take on their tax return. 

Do You Get Tax Relief on Depreciation?

Yes, depreciation is an annual income tax deduction. Businesses can claim this deduction for the effective depreciation of certain assets. In other words, depreciation allows businesses to recover the cost of certain assets over a number of years by deducting a part of the cost every year until the cost has been fully recovered.

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, these methods are typically industry-specific. The four depreciation methods include straight-line, declining balance, sum-of-the-years’ digits, and units of production.