All You Need to Know About Accumulated Depreciation vs. Depreciation Expense

Ines Zemelman, EA
Ines Zemelman, EA
• 28.09.22 • 5 mins read

When it comes to accumulated depreciation vs. depreciation expense, the fundamental difference is that one is reported as an expense (depreciation) on the income statement, while the other appears on the balance sheet as a contra asset (accumulated depreciation). 

However, both refer to the decay or wearing out of machinery, various kinds of equipment, or other assets. Moreover, both aid in stating the true worth of an asset, which is critical when calculating year-end tax write-offs or when selling a business. Let’s explore and learn about when to depreciate vs. expense.

Accumulated Depreciation vs. Depreciation Expense: The Difference

The tax bill, net profit, and overall worth of your company are all impacted by depreciation. Given how depreciation impacts your business, here are some basic terms you should be familiar with:

Accumulated Depreciation

Accumulated depreciation is the running sum of depreciation costs for an asset reported on the balance-sheet asset. During each fiscal year, the original value of an asset is adjusted to reflect its current, depreciated value. For example, in year three of ownership, a machine, which was originally purchased for $500,000, is now recorded as having a worth of $300,000. Again, investors should keep a close eye to ensure management isn't trying to inflate book value by manipulating depreciation calculations. However, this strategy is frequently employed to lower the book value of assets. 

This is done for several reasons. Still, the two most essential is that the corporation can claim bigger depreciation write-offs on their taxes and that it increases the gap between liabilities and revenue. By doing this, the company's financial situation will appear more promising than it actually is.

Depreciation Expense

When it comes to depreciation vs. expense, depreciation expense is presented on the income statement just like any other usual business expense. If the asset is utilized for production, then the expense is reported under operating expenses on the income statement. This amount represents a portion of the asset's purchasing price for production purposes.

For instance, factory machines used to manufacture the main product of a garment company have attributable revenues and expenses. To calculate depreciation, the company would assume an asset's useful life and scrap value.

The annual depreciation expense for a machine worth $500,000 that is anticipated to be worth $100,000 after five years is $80,000. This equals ($500,000 - $100,000) / 5 = $80,000.

Life expectancy and scrap value guidelines are sometimes unclear. Therefore, potential investors should be careful of exaggerated claims on scrap value and life expectancy, the longevity or salvage value of an asset.

Depreciation vs. Expense: Difference

So, is it better to depreciate or expense? Depreciation is used by almost every company in its income statement. Since it is categorized as an expenditure, it must be factored in anytime a final tally is done for the year's taxes or figuring out if an item is valid for liquidation.

Accumulated depreciation is typically not recorded separately on the balance sheet, as long-term assets are listed at their carrying value, net of accumulated depreciation. Since this information is not readily available, calculating the accumulated depreciation connected to a company's assets can be difficult.

How To Decide Whether to Expense or Depreciate Assets?

Determining whether a business should expense or depreciate a purchase or asset for calculating taxable revenue is both an art and science. While the IRS provides guidelines for handling particular transactions and amounts, you still have some leeway when filling out your tax forms. Although choosing to expense an asset instead of depreciating it is more beneficial to your company's cash flow in the short term, doing so may not be a good financial decision in the long run. Here is what you need to consider when deciding whether to expense or depreciate assets. 

Consider the Business's Financial Situation

When deciding whether to expense an item or depreciate an asset, you should examine the present and future financial state of the business. Although expensing a purchase may increase short-term revenue, once you've done so, the item is no longer eligible for write-offs on subsequent tax returns. A depreciating asset might cost less upfront, but it might also mean paying less tax down the road. Consider the business's present and foreseeable financial demands when it comes to expense vs. depreciation, as well as which would result in higher benefits.

Understand the IRS Guidelines

When deciding what can be depreciated and when to depreciate vs. expense, it is helpful to grasp the guidelines provided by the Internal Revenue Service (IRS). 

  • Typically, automobiles, computers, and other office equipment depreciate within five years.
  • Building fixtures and office furniture have a seven-year depreciation term.
  • Rental property and buildings have a depreciation period of 27.5 years.

Calculate Your Depreciation

Determine your estimated depreciation using IRS Publication 946 before deciding whether to expense or depreciate your assets. Depreciation is calculated in accordance with the Modified Accelerated Cost Recovery System (MACRS). This popular tax program allows you to write off more of an asset's cost in the first few years of its useful life and less in later years. For individuals who would prefer to wait before deducting costly expenditures, this is a fantastic compromise that nevertheless provides a boost to cash flow right away.

Consider Section 179

In order to encourage small firms to invest in capital equipment and other high-priced things, the IRS created Section 179, which allows certain purchases to be written off as an immediate business expense rather than a depreciable asset. With the help of Section 179, small businesses might potentially reduce their tax liability for the current tax year and make crucial investments in their operations. The highest allowable deduction under Section 179 is $1,050,000, and the maximum allowable value of the bought property is $2,620,000. You might want to check out the IRS's website for more details.

The Bottom Line

When deciding between accumulated depreciation vs. depreciation expense in business tax planning, it's important to know that the annual depreciation expense listed on the income statement is typically more accessible than the accumulated depreciation on the balance sheet. As a major non-cash expense, annual depreciation is often added back to profits before interest and taxes (EBIT) to calculate EBITDA. While accumulated depreciation helps gauge the age of a company's assets, it isn't always clearly presented in financial statements.