Deprecation – what is it?
When we use the word “depreciation,” we generally refer to a decline in the value of something, usually a large item with a relatively high cost. We’ve heard the word used in connection with a new car: drive it off the lot and it loses, or “depreciates,” one-third of its original value.
In accounting and taxation however, depreciation has a completely different meaning. In this case, we’re referring to spreading the cost of an item over its estimated useful life, rather than trying to estimate its current value.
The “item” is something owned by the business that has a high cost, and is usually referred to it as a “fixed asset.” For racers, examples of fixed assets include the racecar, the engine(s), high-cost items such as alignment equipment or a dynamometer, the garage itself, and the lifts and hoists for the car and engines.
The “cost” of the fixed asset includes not only the original cost, but also shipping and setup costs. The cost of additional work done to make it race-worthy is also added to the cost. Examples include major engine or chassis modifications.
For accounting purposes, the “useful life” is normally determined by the business as long as it’s reasonable and consistently applied.
On the Books of the Business…
This annual “spreading” of the fixed asset’s cost is called depreciation. Each year of a fixed asset’s useful life, depreciation expense is increased by the annual deprecation. This shows up on the income statement (often called the “profit and loss” or “P & L” sheet) and reduces the business’s net income or profit.
On the balance sheet, which lists all the assets and liabilities (debt) of the business, the annual deprecation expense is indirectly deducted from the cost of the asset. The result is that, at the end of a fixed asset’s useful life, its remaining value is either zero or an amount that represents scrap value.
In accounting and tax lingo, the word “basis” is often used to describe the cost of the fixed asset as reduced by the accumulated depreciation.
Take a simple example: A racing team purchases a dragster for $65,000 and spends an additional $5,000 on it, making the total cost $70,000. The owner of the team estimates its useful life to be five years. He or she also estimates its scrap or salvage value to be $10,000. Result: on the books, the total amount to be depreciated will be $60,000 ($70,000 minus $10,000) over the five years, resulting in $12,000 annual depreciation ($60,000 divided by 5 years).
So, each year there will be $12,000 in additional expense on the profit and loss statement, which reduces the net income or profit of the racing business. And the same $12,000 serves to annually reduce the remaining cost (or “basis”) of the dragster on the balance sheet.
(Yes, the annual depreciation amount is recorded twice – in this case, on the balance sheet and on the profit and loss statement. No, we’re not “double-dipping” or “keeping two sets of books.” Each business activity affects at least two different accounts. That’s why it’s called “double-entry bookkeeping.”)
In the “real world,” the first year’s deprecation is “pro-rated” or allocated based on the time of purchase during the year. In the above example, if the dragster were purchased in April, the first year’s depreciation would cover nine month’s of a year (April through December). In this case, the first calendar year would show a depreciation expense on the income statement of $9,000 ($12,000 x 9/12).
For Tax Purposes…
Tax depreciation has a number of differences from the depreciation used in accounting. (That’s one of the things that makes tax work complicated: it starts with the accounting records, but makes changes to conform to tax law.)
First, you don’t choose the useful life of a fixed asset for tax purposes. The tax law specifies the useful life of various fixed assets. (For tax purposes, the useful life for racing cars is seven years.)
Second, don’t worry about the “scrap” or “salvage value” of the fixed asset. The tax code doesn’t recognize it, which produces two good results: first, your taxes will be lower, since you will eventually depreciate the entire cost of the asset, and second, you don’t have to spend the time figuring out the scrap value.
Third, the annual depreciation expense does not normally use the same amount each year (so-called “straight-line” deprecation.) The IRS has a set of tables that allow for a greater amount of deprecation to be taken in the earlier years.
Fourth, you don’t have to worry about calculating the first year’s depreciation based on when you purchased the racecar. You get a half-year of depreciation in the year of purchase and in the final year of depreciation, regardless of whether you purchased the fixed asset in January or December.
In some ways, tax depreciation is simpler than the depreciation computation for accounting. The tax depreciation tables provided by the IRS are easy to read and the annual tax deprecation is easy to compute. Let’s take the previous example of the dragster and see how it would appear on the racing team’s tax return for each year.
The annual percentages for the tax deprecation of seven-year property are:
Year %
2 24.49%
3 17.49%
4 12.49%
5 8.93%
6 8.92%
7 8.93%
8 4.46%
You might look at the table and wonder if the IRS can count. I mentioned that the IRS assigned a seven-year life for the racecar, and yet there are eight years in the table. This is one of the strange things about tax deprecation: the deprecation table is increased by one year because the asset gets half-year deprecation in the first year and the other half-year occurs in the final year. Two half-years make one extra full year. See how it works out below.
The annual tax deprecation expense for the dragster would be:
Year % Cost Annual Depreciation
1 14.29% x 70,000 = $10,003
2 24.49% x 70,000 = $17,143
3 17.49% x 70,000 = $12,243
4 12.49% x 70,000 = $ 8,743
5 8.93% x 70,000 = $ 6,251
6 8.92% x 70,000 = $ 6,244
7 8.93% x 70,000 = $ 6,251
8 4.46% x 70,000 = $ 3,122
Totals 100.00% $70,000
For tax purposes, businesses can immediately deduct the cost of certain fixed assets up to a specified amount in the year of purchase, rather than depreciating them over their useful lives. This amount changes from time to time as Congress adjusts it in response to economic and political considerations. A word of warning however: if you take this additional first year (or “bonus depreciation), it could create potential ramifications in the future. Seek the advice of a tax advisor.
Other Thoughts…
If you think about it, the financial statement that you give to your bank in the hope of getting a loan and the tax return for the racing business will show different amounts of deprecation expense and, thus different profit amounts. Don’t worry – we’re dealing with two separate sets of rules, so we’re bound to get two different results.
Which is correct? Both are! The accounting records show the activities under the rules for generally accepted accounting principles, and the tax return shows the results under the tax law. (Tax accountants deal with this stuff all the time.)
Although there’s software available to do these computations, it’s easy to see the need for having an accounting advisor just as you need technical advisors to handle the challenges associated with racing.
Normally, one set of headaches is enough.
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I’ve tried to keep this material as simple and understandable as possible. Sometimes, though, it can be a problem. First, the material is complex and, second, the way the numbers and tables show up on the blog, I’m wondering if there isn’t a better way to display it.
To solve this last problem, I’m thinking about moving to a website, and I’d like your opinion on it, as well as comments or questions on any of the information that’s been covered.
Also, let me know if you or your group would be interested in a presentation going into these topics or other tax and financial aspects of motor sports. I'd be interested in hearing from you.
Contact me at:
Also, let me know if you or your group would be interested in a presentation going into these topics or other tax and financial aspects of motor sports. I'd be interested in hearing from you.
Contact me at:
Until next time …
Phil Schurrer, CPA
“This posting is intended to provide general information regarding the subject matter covered. It is provided with the understanding that the author is not engaged in rendering legal, accounting, or other professional services. This information should not be used as a substitute for professional advice in specific situations. If legal advice or other expert assistance is required, the services of a professional should be sought.”
- Adopted from a Declaration of Principles jointly adopted by a Committee of the American Bar Association and a Committee of Publishers.
Attorneys and other professionals dealing with specific matters and situations should also research original sources of authority.
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