Whether
you're talking about an investment in a new corporation or a patent
on a new invention, most assets are more useful when first acquired
than they are a few years later. Accountants use depreciation and
amortization to spread out the costs of assets during the years a
company uses them.
Accountants can choose from among a variety of depreciation
methods, based on the specific characteristics of an asset, says
Peter H. Knudson, associate professor of accounting emeritus at the
Wharton School at the University of Pennsylvania in Philadelphia.
All methods try to distribute the cost or other basic value of
assets, minus any leftover salvage value, over the asset's estimated
useful life.
Generally Accepted Accounting Principles, a bible of sorts for
certified public accountants, even lets a company use one method of
depreciation in tax filings but another when reporting its earnings
to shareholders. For the latter, companies will often spread some of
their expenses over several years to boost profits while being
honest with shareholders about the costs of doing business.
But in tax filings, companies typically want to take the biggest
possible deductions as quickly as possible to lessen the tax bite.
Keeping Expenses in Check
Reporting small-ticket items such as individual PCs as "expenses"
is an alternative to depreciation in tax filings. But federal tax
law places strict limits on the amount that can be claimed as
expenses.
The government is gradually raising the ceiling on a company's
overall expenses that can be written off without being depreciated
-- from $18,500 in 1998 to $19,000 this year and $25,000 in 2003,
says S. P. Kothari, professor of accounting at MIT's Sloan School of
Management in Cambridge, Mass.
At the same time, prices are falling on such IT items as
individual PCs. Because of the coincidental collision of these two
factors, a company might now be able to write off more computers
through the expense method than before. Small businesses will be the
biggest beneficiaries.
There are also different rules to distinguish between
depreciation and amortization. All intangible fixed assets must be
amortized on corporate financial statements. But some of these
intangible items, such as trade names, can't be amortized in tax
filings. "Anything that has an 'indefinite life' -- a life that just
seems to go on and on -- cannot be amortized for tax purposes,"
Knudson explains.
As the pace of technological obsolescence has quickened, the
federal tax code hasn't tended to keep pace. Under the tax laws,
tangible fixed assets have been traditionally valued according to
"physical life span," or the period of time they are expected to be
functioning, operational or otherwise useful.
"But you might be lucky if your computer lasts two years without
becoming obsolete" and needing to be replaced, Knudson observes.
In reporting earnings to shareholders, companies are more likely
to use conventional straight-line methods, which depreciate the same
amount of cost each year rather than depreciating more during the
first few years after the purchase of a major asset. The reason: The
straight-line method results in lower expenses -- and, consequently,
higher profits -- in the first few years after the purchase.
However, accountants tend to use various forms of accelerated
depreciation in tax filings, especially when writing off IT
investments.
Even if a company uses an accelerated method, it can switch to
straight-line depreciation for the remaining life of the asset as
soon as it reaches a point where straight-line depreciation allows
it to write off the remaining value more quickly.
But it doesn't seem like any method of depreciation or
amortization is entirely flawless. One negative aspect of
accelerated depreciation, for example, is that companies write off
less in their tax filings in an asset's later years -- until they
invest in newer assets.
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