Know When, How To Depreciate Equipment
BY Sean Rizer
Evaluating capital expenditure needs is not always a straightforward decision. Decisions such as when to buy are dealt with on a regular basis. This conversation occurs frequently when it relates to pavers and what is the right strategy for the business.
In this case study, we will focus on a paver and assume an original purchase cost of $500,000. While not every company is positioned to purchase pavers in this price point, it will serve as a good base line for the concept. This case study also is intended to provide different ways to evaluate the transaction and companies should always consult their financial advisors on how these transactions would impact your specific situation.
Finance or Cash & Recordkeeping
The decision to outlay cash in full or finance is one that has been debated since companies started purchasing pavers. Several factors play into this determination and most companies starting out don’t have the capital reserves to pay cash for their first paver purchase and will finance instead. Another reason a company finances a paver is to match the cash out flow (loan payment) with the cash inflow (sales generated with the paver). For companies who have seasonal periods of no revenue, “token” loan payments are a great tool to use to preserve cash in months where the paver can’t be used. This can be a great tool to preserve a company’s cash and invest in other parts of the company.
Contractors are frequently required to keep their books and records for external financial reporting purposes under United States Generally Accepted Accounting Principles (U.S. GAAP). This allows users of the financial statements to assume the numbers are presented in a similar format to your peers for comparability purposes. One question that arises after the purchase of a $500,000 paver is, how do I reflect that paver on my books? The paver is shown as a long-term asset, which is offset by depreciation over time. Depreciation can be calculated several different ways and will yield different results for interpretation of the user of your financial statements.
Depreciation: Book Methods
Two common ways of recording depreciation for U.S. GAAP are the straight-line method and units of production.
The straight-line method takes the cost of the paver less residual value and spreads it evenly over the economic useful life of the paver. This method does not consider how much the paver is used in each year.
Straight-line is the most common way companies track depreciation for U.S. GAAP.
A second method of book depreciation is units of production. If a company determines the life of a paver is 5,000 hours, the monthly depreciation is based on the actual hours recorded for the paver. This method would be considered more reflective of actual usage; however, it is more involved in coordination of information gathering to calculate the depreciation. For companies that are seasonal, this method may be preferable to show depreciation in months when the company is using the paver and not in winter months.
Residual (Salvage) Values
For U.S. GAAP reporting purposes, it is an acceptable practice to show a residual (salvage value) of the paver. By recording a salvage value, the paver is always reflected at some amount on its balance sheet, even if it is $50,000 on a paver initially purchased for $500,000. While this may not sound significant when talking about one paver, this concept should be applied for all heavy equipment and when done can amount to a significant value of equipment.
Depreciation: Tax Methods
For federal income tax reporting purposes, depreciation is typically calculated one of two ways: under the current tax law as of the date of this article publication, bonus depreciation and MACRS depreciation.
Bonus depreciation allows the company to depreciate (expense) 100 percent of the paver in the year of purchase. Companies often elect this method to accelerate the depreciation to minimize federal income tax liability in the year of purchase. Companies who elect this method must also be aware of the impact on the next years of ownership and there will be no depreciation to offset income.
A second method is MACRS, which depreciates the paver over a five-year period with more depreciation per year in the earlier years. A point worth mentioning is each state has its own laws on depreciation methods, so you should always consult your tax advisor regarding the acceptable depreciation methods in your state.
Hidden Equity and Value over Time
It is common for contractors to keep one set of financial records for simplicity reasons, which typically is the method used for tax reporting purposes. As we will see in the chart on this page, using tax basis depreciation methods can accelerate the amount of depreciation shown and lower net profit in early years; however, it also accelerates the reduction the equity or “net worth” of the business. For companies who submit financial statements for prequalification showing as much net worth as possible, it provides the strongest financial snapshot of the company.
Let’s look at a chart to illustrate the differences in depreciation over time. Bonus depreciation gives the company the largest expense in the first year, but no depreciation in later years. The units of production method varies each year depending on how many hours the paver is run. So in year three, the company had the heaviest usage of the paver and recorded the largest expense.
Each method of reporting has positive and negative attributes about them and it is critical for a business owner to understand how each method of reporting impacts its financial reporting.
Sean Rizer is the CFO for Harding Group, Indianapolis, Indiana, which performs asphalt services, supplies hot mix asphalt and provides dump truck transportation. Prior to joining Harding Group, Rizer spent over 10 years in public accounting, providing operational and transactional consulting. He graduated from Valparaiso University with a bachelor’s degree in both accounting and finance.