Understanding depreciation and amortization is crucial when calculating business deductions. These deductions adhere to guidelines set by U.S. law. Financial officers must understand how to navigate these regulations in order to manage their company’s finances.
In this article, we’ll explain how corporate depreciation and amortization work, as well as the laws that govern them.
What is the Difference Between Depreciation and Amortization?
Both depreciation and amortization represent accounting methods that relate to the decrease in the value of a business asset.
Typically, depreciation is used to refer to physical assets, illustrating the reduction in useful value over the lifetime of the asset, such as office furniture or a company vehicle.
Amortization, on the other hand, is an accounting technique that reduces the value of a loan or other intangible asset over a period of time.
How to Calculate Depreciation and Amortization
Depreciation and amortization can be calculated in three main ways:
The Straight-Line Method
The default method for calculating depreciation is known as the “straight-line method.” In this method, an asset is devalued gradually over the course of its life. For accounting purposes, each fiscal year will use the same percentage of the asset’s cost when calculating depreciation (e.g., 20% each year).
Declining Balance Method
This method takes into account the fact that assets tend to depreciate most rapidly early in their lifespan. It’s common to employ either a 200% declining balance method or a 150% declining balance method. As you’ll see in a moment, there are some regulations that demand one over the other.
Sum-of-the-Year’s Digits Method
Finally, this method takes the asset’s expected lifespan and adds the digits for each year. For example, if a desk is expected to last four years, you would add each year of its projected lifespan (4+3+2+1) to get a total of 10. Then, each year of its lifespan would be divided by this number to arrive at a percentage of its overall depreciation.
What Are Depreciation Deductions?
Depreciation deductions may be taken for tangible property, but there are some stipulations about how the value is calculated.
For property placed in service after 1986, you must calculate the capital costs using the modified accelerated cost recovery system (MACRS). This system sets different parameters based on the asset’s recovery period, which may be one of the following:
- 3 years
- 5 years
- 7 years
- 10 years
- 15 years
- 20 years
- 27.5 years
- 39 years
However, if the property was placed in service prior to May 13 of 1993, a recovery period of 31.5 years applies. These periods are important, as they impact the way deductions are calculated.
Three- to Ten-Year Class
Property in the three- to ten-year class should be calculated by combining two depreciation accounting methods as follows:
- Start by using the 200% declining-balance method
- Switch to the straight-line method once this method maximizes deductions
Combining these methods ensures maximum deductions.
Fifteen Years and Over
Property in the 15 to 20-year class is depreciated in a similar manner:
- Start by using the 150% declining-balance method
- Switch to the straight-line method once this method maximizes deductions
However, it may also be possible to use the alternative depreciation system, which is basically the straight-line method over prescribed lives.
Residential and Non-Residential Property
Depreciation to property may be determined as follows:
- For residential rental property: use the straight-line method over 27.5 years
- For non-residential real property: use the straight-line method over 39 years
Though, again, 31.5 years should be used for property placed in service prior to May 13 of 1993.
Automobiles
Depreciation deductions can only be used for vehicles that are used for 50% or more of the business. Additionally, there may be dollar limitations assigned to depreciation deductions for vehicles placed in service after 1986.
Understanding How Amortization Impacts Your Business
Depreciation and amortization both have an impact on your deductions, though as we’ve seen, they apply in slightly different ways.
As a general rule, the cost of most intangible assets is capitalized and amortized at a steady rate over 15 years.
While rapid amortization may be available for pollution control facilities, the majority of U.S. businesses can rely on a more regular form of amortization.
Amortization Regulations
Additionally, different intangible assets may be amortized in various ways. For instance, recent tax changes have meant that companies are required to amortize their research and development costs over a five-year period, which could impact a company’s ability to innovate and implement new technology.
Amortization and Tax Preparation
Ultimately, understanding amortization relating to your intangibles is essential for tax preparation and planning. By amortizing intangible assets, you can effectively reduce your overall taxable income (and therefore your tax liability). This can also give investors a better understanding of your company’s overall earnings.
Depreciation and Amortization and Deductions
The value of your assets changes over time. By understanding how this value changes, you will be in a better position to navigate existing tax law, maximize your deductions, and increase financial transparency for your investors.
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Additional Resources
Looking at the Regulatory Plans for 2021
Changing US Tax Policy: What it Means and How to Stay Compliant
Tax Season is Coming: Forgiveness, Denials, and a Lot of Tax Complexity
