Monday, April 28, 2008

Depreciation - The Hard Way or The Easy Way

I have often said that there are 2 ways to do things: the hard way and the easy way. The hard way takes less time up front but more time in the long run. Naturally, the easy way takes more time up front but less time in the long run.

Depreciation calculations and recordkeeping used to be tedious and difficult. That was before software. Once you know how to properly use the software, it isn’t that bad anymore.

Why I bring this up is that too often I’m seeing companies having no differences between their book (GAAP) depreciation and their tax depreciation. This gets to be a big problem when there have been substantial Section 179 deductions take in recent years.

Section 179 is a part of the Internal Revenue Code that allows a business to immediately expense, subject to limitations, certain property and equipment purchases. The alternative would be to depreciate these items over time. For 2007, the maximum deduction was $125,000.

The problem is that you can’t take a Section 179 deduction in a GAAP basis financial statement. GAAP requires you to expense long-lived assets over their estimated useful life and using an acceptable depreciation method (such as straight-line or double declining balance). Immediately expensing property and equipment purchases means you are overstating expenses and understating assets.

The tendency to assign the same depreciation method and useful life for tax and GAAP has greatly contributed to this problem. Tax depreciation methods, commonly referred to as MACRS depreciation, are often reasonable for GAAP. For example, MACRS depreciates equipment usually over a 7 year life on a 200% double declining balance method. This is generally a reasonable estimate for GAAP too.

What happens is people just automatically copy over the tax depreciation treatment for the GAAP treatment. And they start taking Section 179 for book and tax.

This becomes a problem when the business wants a CPA to issue an audit, review or compilation report on its financial statements. This often occurs when a company wants to borrow money from a bank and for many other reasons. If the financial statements are to be on a GAAP basis, the CPA will have to disclose the departure from GAAP, or fix it. Fixing it costs money. The alternative is issuing what we call an OCBOA (Other Comprehensive Basis of Accounting) statement – this means you are producing financial statements but they aren’t GAAP. Many companies do this, but I advise against it if possible.

Frankly, the technology is there. Take the 10 extra seconds when you enter an asset into the fixed asset software and give it an intelligent depreciation method that reflects what you expect to occur in your business. And don’t take a Section 179 deduction for book.

Like I said at the beginning, there are 2 ways to do things. The hard way here is to take shortcuts. It will cause you problems in the end. Invest 10 more seconds (or whatever it takes) and do it right up front.

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