Depreciation rate

From CEOpedia | Management online

Depreciation is the reduction in the value of property, plant, and equipment over time as a result of their use. Charging of depreciation means the recovery of invested capital, by the gradual sale of the asset. Depreciation is charged at the end of the accounting year using the best method for the appropriate asset.

Depreciation rate it is a percentage determination of what part of the value of a given asset can be accounted for during the year. "The choice of depreciation rates has also been included by the requirements of tax law and regulation." (D. R. Carmichael, Lynford Graham, 2009, p. 156). In Polish law, the rate can be found in the Act on Personal Income Tax in the List of Annual Depreciation Rates. And so in the case of e.g.

  • non-residential building - the rate is 1.5%,
  • car - the rate is 20%,
  • computer teams - the rate is 30%.

Determining the depreciation rate with the straight-line method

"The depreciation rate (in percentage terms) may also be determined by dividing the specified declining-balance percentage (150 percent or 200 percent) by the applicable recovery period.

A depreciation rate based on the straight-line method is used beginning in the tax year in which the depreciation deduction is greater than the depreciation deduction that would result using the 150-percent or 200-percent declining-balance method (whichever is applicable for the property)." (CCH Tax Law Editors, 2007, p. 300)

Group and composite rates

For depreciation of asset groups, maybe depreciation at a single rate can be used. These groups include the assets of electrical utilities and hotels. The group depreciation method and the collective depreciation method are the most commonly used depreciation methods. Group depreciation is defined as the "process of averaging the economic lives of a number of plant assets and computing depreciation on the entire class of assets as if it were an operating unit. […] Because the accumulated depreciation account under the group procedure applies to the entire group of assets, it is not related to any specific assets. Thus, no book value can be calculated for any specific asset and there are no fully depreciation assets. To arrive at the periodic depreciation charge, the depreciation rate is applied to the recorded cost of all assets remaining in service, regardless of age." (D. R. Carmichael, Lynford Graham, 2009, p. 156)

Application of the MACRS (Modified Accelerated Cost Recovery System) table

"When the optional MACRS rate tables are used, the percentages from the tables are applied to an asset's unadjusted basis, as determined for the year the property is first placed in service, to compute the depreciation deduction. That figure is used for each tax year that the MACRS rate tables are used for that property. If the taxpayer discontinues using the MACRS rate tables, then the unrecovered basis must be determined for the year of the change and for each year thereafter to compute the MACRS depreciation deduction." (Bruce K. Benesh, M. Kevin Bryant, 2019, p. 82)

"Special rules apply to MACRS deductions in tax year of less than 12 months (a short tax year). [...] A special set of rules applies in calculating the MACRS deductions in tax years consisting of less than 12 months ("a short tax year"). The optional MACRS rate tables provided by the Service cannot be used. The depreciation allowance is determined in a short tax year by:

  1. multiplying the taxpayers property's basis in the property by the applicable depreciation rate; and
  2. the multiplying that number by a faction, the numerator of which is the number of months (including fractions of months) the property is deemed in service during the short tax year under the applicable convention and the denominator of which is 12" (Bruce K. Benesh, M. Kevin Bryant, 2019, p. 104)

Examples of Depreciation rate

  • Straight-line Depreciation: This is the most commonly used method of depreciation. It is calculated by dividing the asset's cost by its estimated useful life. The amount of depreciation is the same each year and is based on the original cost of the asset. For example, if a company purchases a machine for $100,000 and it is estimated to last for 5 years, the annual depreciation expense will be $20,000.
  • Accelerated Depreciation: This method allows companies to accelerate the depreciation expense, meaning that more of the cost of the asset is expensed in the early years of the asset's useful life. This is usually done to take advantage of tax deductions in the earlier years. For example, if a company purchases a machine for $100,000 and it is estimated to last for 5 years, the depreciation expense may be $40,000 in the first year and then $20,000 each of the following four years.
  • Units of Production Depreciation: This method is used when the useful life of an asset is related to its production output. The depreciation expense is calculated by multiplying the total cost of the asset by the total number of units produced by the asset. For example, if a company purchases a machine for $100,000 and it is estimated to produce 100,000 units over its useful life, the annual depreciation expense would be $1,000 ($100,000 divided by 100,000 units).

Advantages of Depreciation rate

Depreciation is a necessary accounting practice which is used to spread the cost of a business asset over its useful life. It has several advantages, including:

  • Reducing taxable income: Depreciation reduces the amount of taxable income a business has, as it allows businesses to write off the cost of assets over time. This results in lower taxes, which can help businesses save money.
  • Matching expenses with revenue: Depreciation matches expenses associated with a business asset with the revenue generated by the asset, which is important for accurate financial statements.
  • Reflecting the true value of assets: Depreciation helps to reflect the true value of assets, as it takes into account the impact of deterioration, wear and tear, and obsolescence. This helps to ensure that assets are valued properly, which is important for accurate financial reporting.
  • Providing liquidity: Depreciation can provide businesses with additional cash flow, as it reduces their taxable income and increases the amount of money available for reinvestment or other uses.

Limitations of Depreciation rate

  • Depreciation rates can be subjective and difficult to determine accurately. For example, the useful life of an asset may differ based on its purpose and environment.
  • Depreciation rate is an estimate of the rate at which an asset's value declines over its useful life. It is difficult to accurately estimate the rate of depreciation of an asset in advance and this can lead to a difference in the actual rate of depreciation compared to the estimated rate.
  • Depreciation rates can be difficult to change once established, as different methods of depreciation require different tax treatment.
  • Depreciation rates can be affected by changes in tax laws, which may result in a lower or higher rate of depreciation.
  • Depreciation rate also does not consider inflation or other economic factors that can affect the value of an asset over time.

Other approaches related to Depreciation rate

Depreciation is an important tool used to recover invested capital in a business. There are multiple approaches to calculating depreciation rate, including:

  • Straight-Line Method: This method involves charging a fixed depreciation amount for each period for the life of the asset.
  • Double-Declining Balance Method: This method involves charging a higher depreciation rate in the early years of an asset's life, compared to the straight-line method.
  • Sum-of-the-Years-Digits Method: This method involves charging a higher depreciation rate in the early years of an asset's life, compared to the straight-line method.
  • Units-of-Production Method: This method involves charging a constant rate of depreciation as a percentage of the total number of units produced.
  • Component Depreciation Method: This method involves grouping an asset into multiple components, and charging a separate rate of depreciation for each component.

In summary, there are multiple approaches to calculating depreciation rate, such as the Straight-Line Method, the Double-Declining Balance Method, the Sum-of-the-Years-Digits Method, the Units-of-Production Method, and the Component Depreciation Method. Each approach has its own benefits and drawbacks and should be chosen based on the specific needs of the business.

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Author: Weronika Chudzik