The Do's & Don'ts of Depreciation

June 1, 2004
As a mergers and acquisitions specialist and consultant exclusively devoted to the rental industry, I am no longer involved in the practice of accounting,

As a mergers and acquisitions specialist and consultant exclusively devoted to the rental industry, I am no longer involved in the practice of accounting, but I find my accounting experience being put to use on a daily basis. As a licensed CPA in the state of Texas and having worked for a public accounting firm prior to my 16 years in the rental industry, I've seen a lot of different accounting and depreciation methods used in all types of rental businesses. I occasionally dust off an accounting book or two of mine to verify methods and Generally Accepted Accounting Principles (GAAP). As we all know, the tax laws are ever-changing, nevertheless, there are some basics that we should all be aware of regarding depreciation and the best place to start is with overall definitions.

The American Heritage Dictionary defines the word “depreciate” as follows: 1) To lessen the price or value of. 2) To make to seem less valuable or important; disparage. To diminish in value. My trusty old accounting book defines depreciation as “the measurement and reporting of the using up of the service potential of assets.” The accounting book further states that the causes of depreciation can be physical or functional. Physical factors include wear and tear from use and the effects of wind and rain, and functional effects include obsolescence and the decline of replacement cost.

Skid-steer loader
Original cost= $20,000
Sell at end of five years for $7,000   5-year life 7-year life a. Original cost $20,000 $20,000 b. Useful life for depreciation (years) 5 7 c. Annual straight line depreciation expense (a/c) $4,000 $2,857 d. Total depreciation expense over five years (c × 5) $20,000 $14,286 e. Net book value after five years (a - d) $ 0 $5,714 f. Sales price $7,000 $7,000 g. Gain on sale of equipment (f - e) $7,000 $1,286 Total effect on income statement over the life of the asset (d - g) $13,000 $13,000

My partner, Fred Hageman, and I routinely advise all of our clients to have a knowledgeable and competent accountant who knows and understands your business in particular and the rental industry, in general. Your accountant, whether he or she is an employee of your company or with an outside accounting firm, should become a trusted member of your inner circle. Monthly financial statements should be prepared and analyzed on a monthly basis. Cash budgeting and financial projections should be used to prepare a capital expenditures budget that details the nature, amount and timing of planned investment in rental fleet.

With today's new depreciation laws, your accountant can help you time your fleet purchases for maximum tax effect. To do this, he or she must be fully informed on where your business stands financially at a given point in time.

Probably the most important thing to understand about depreciation is that it is an estimate. Go back and look at the definition and you will see a form of the word estimate in both definitions. When an asset is sold, scrapped or retired there is a “settle up” process in which a gain or loss is recognized against your net book value (depreciated value of an asset). Let's take an example. You buy a skid-steer loader for $20,000 and sell it in five years for $7,000. Regardless of your depreciation method, the net effect on your financial statements — even if you don't depreciate it all — will always be $13,000. In other words, it cost you $13,000 to own that skid steer — excluding maintenance, insurance and interest — for five years. The table above illustrates the net effect of a five-year depreciation schedule vs. a seven-year depreciation schedule.

You can run the numbers any way you like. Change depreciation methods, length of depreciation the sale amount or any other factor, and in the end it all equals out. The only difference your method of depreciation will make is in the timing of the effect on your profit and loss statement.

With these basics of depreciation in mind, here are some basic do's and don'ts of depreciation:

DO take advantage of the new tax laws. For 2004, Section 179 allows a deduction of up to $100,000 for new equipment purchases. On other assets, bonus depreciation of 50 percent of the cost is allowed in the first year in addition to the normal depreciation.

DO consult your tax professional to determine how this can benefit your company based on its tax structure. At a minimum, you should consult with your tax advisor quarterly as estimated tax payments are due.

DON'T forget that depreciation is all about timing. In the case of taxes, it depends on whether you want to pay tax now or pay tax later. Because of the time value of money, it's almost always advantageous to pay taxes later or “defer” your tax liability. In future years, when you go to sell the assets you've taken these write-offs on, the sale will most likely result in a taxable gain, possibly even causing additional tax due to “re-capture” the depreciation previously expensed. Re-capture gains are paid at higher ordinary income rates as opposed to lower capital gain rates.

You should discuss with your tax advisor and understand when re-capture may apply. Depending on your tax situation and legal entity structure, this concept could apply whether you're selling individual assets or your entire business.

DO have a clearly defined policy on what you expense as purchased vs. what is capitalized and depreciated. Most companies expense purchases under a threshold of $500 to $1,000, assets that have a useful life of less than two years, and non-serialized or “bulk” items.

DO keep track of the expensed items as they have value for your business even though they are not recorded on the books.

DO keep detailed asset records with individual asset descriptions, serial number, acquisition date, original cost and net book value. DON'T group assets together with descriptions like “March 2004 purchases.”

DO remove assets from your records when they are sold, even if they are fully depreciated. This is a common problem we see when evaluating businesses day in and day out. Old assets that have been sold or scrapped are distorting the records and can be problematic if you ever sell or transfer your business.

DON'T be afraid to keep two sets of books, one for financial reporting purposes and one for tax purposes. The new tax laws diminish your book value quickly but are not in accordance with GAAP. Banks, investors or someone interested in buying your business may not be willing to loan or pay full value for your business based on low net book values created by accelerated tax depreciation methods.

DON'T use the net book value of an asset to determine its selling price. Always try to maximize the selling price of an asset, regardless of its book value. I know of some companies that will not allow its managers or sales people to have access to book values for this very reason. Remember, depreciation is only an estimate in the decline in market value. Actual market value of an asset may be much greater or much less than its depreciated value depending on market conditions. Hageman and I believe that the sale of used equipment should be a source of profits and cash flow for a rental business and that used equipment should be viewed as a source of unrealized equity in your rental business.

DO try to match your book — but not necessarily tax — depreciation method to its actual life. We find many times that a fleet that has been properly depreciated on an overall basis will have a net book value very close to its fair market value. From an accounting standpoint, this is what you are ultimately trying to accomplish. The best rule of thumb here is your prior experience with similar assets.

DO remember to take into account your true equipment ownership costs when setting rental rates. In our skid steer example, the true cost of owning that unit over five years was $13,000 ($20,000 purchase price minus $7,000). Also include maintenance, insurance and interest costs when determining your equipment ownership costs.

DO remember that, when comparing results of your rental company to others, different rental companies handle equipment depreciation in different manners and also handle the financing of equipment differently. The concept of EBITDA (Earning Before Interest, Taxes, Depreciation & Amortization) is used to “normalize” the financial performance of rental companies. As you can see from this article, various methods of book and tax depreciation can greatly affect profitability and the amount of taxes paid. The EBITDA calculation strips away these numbers so that a comparison between individual companies can be made regardless of debt levels, taxes and depreciation methods.

The rules of tax depreciation have changed dramatically over the past several years and will continue to change as political agendas and economic factors change. Be aware of the potential impact on your business and seek sound professional advice on a regular basis. Regardless of how you depreciate your equipment, never lose sight of the fundamentals of keeping good records, negotiating favorable prices with vendors and proactively selling used equipment at a fair market price.

Gary Stansberry is a partner in the consulting firm of Hageman, Stansberry & Associates (HS&A). HS&A specializes strictly in the rental industry offering operational consulting, mergers and acquisitions, and valuation services. More information about HS&A can be found on its Web site at www.rentaladvisors.com. Stansberry can be reached at (817) 563-6882 or by email at [email protected].