The concept of accounting for depreciation has been around since at least the 1800’s. However, it must be noted that the United States did not have income tax until it was signed into law in 1913. So what was depreciation used for in accounting prior to 1913? The answer to that is found in Tiffany’s Digest of Depreciations, 1890 edition, where it proclaims that the book “…will prove of great value and assistance in determining the rates of depreciation on a basis that will not only be equitable as between the Insurer and the Insured, but also prove of assistance to Architects, Builders, Machinists and Contractors in their calculations.”
So depreciation was used for determining insured value of fixed assets during their useful life. It was also very useful for business owners (“Architects, Builders, Machinists and Contractors…”) in calculating the sale price of used assets. If you’re thinking of the Kelley Blue Book, you’re on the right track. Perhaps a bit more confusing is why architects would need to use the depreciation schedule for a building. Do buildings really depreciate? Don’t they last for centuries if maintained along the way? Tiffany’s addressed this concern up front, in the preface of their Digest of Depreciations; “It should be remembered that all percentages on buildings are based on the actual ‘life of the building’ without any repairs. Any repairs such as painting, renewing of roof, siding or flooring, should be credited to the building, and the percent of depreciation reduced...” [emphasis in the original; archaic spelling updated]
Do we see any hint of depreciation being used for tax purposes in Tiffany’s Digest of Depreciations in the 1800’s? No, we do not. Income tax did not exist yet. Then why is depreciation so firmly part of tax accounting today? The cynical answer is that it generates more tax revenue for the government in the short term. But maybe it’s simply because it was in most business accounting ledgers in 1913 and merely got included into tax accounting as a result of its prevalence in companies of the day.
At this point, you might be wondering what’s so bad about using depreciation in tax accounting? Let’s look at an example that illustrates how destructive this one little accounting rule is to American business.
In a nutshell, businesses cannot just "expense" asset purchases including inventory, equipment, buildings, etc. As ordinary people, we know that when we spend money on something, it gets deducted from our income. You spend money, it comes out of your bank account. However, tax accounting rules don’t always work that way with businesses. When a business spends money on assets, that money comes out of the business bank account, just like with an individual. But due to double-entry accounting rules (which go all the way back to 14th century Italy), asset purchases are merely considered an exchange of one asset (cash) for another asset (building, equipment, etc.).
Because of this, the business can only depreciate the asset over a period of years (for tax deduction purposes), even though the business takes the hit to its cash flow only in the year it spends the money. The business really needs to get the expense deduction (to lower its net income) in the year the expense happened in order to maintain a healthy cash flow, but the IRS doesn't allow that. Why? Maybe it’s because if the business was allowed to do that, they wouldn't pay as much in taxes for that year. Then again, maybe it’s merely because the government adopted existing accounting practices in 1913 and never modified them for tax accounting. Of course, the IRS will grant deductions over a period of years, but by then, the business might be out of business due to poor cash flow.
Mandatory depreciation of all asset purchases, whether for a new building or a computer, should be eliminated from IRS rules. Voluntary depreciation, if it helps the long term cash flow of the business, should be allowed, but not be the norm. For example, if a business pays $500,000 cash for a new building (or the down-payment on one, as the case may be), the business should be able to deduct the full $500,000 in that tax year. Why? Because in terms of cash flow, it’s an expense, not income. Unfortunately, businesses are forced to use a 39 year depreciation cycle, effectively nullifying any tax deduction for the huge expense of a new building (the same is true for capital improvements to an existing building, by the way).
So, let’s say that $12,821 (1/39th of $500,000) can be deducted from revenue (a.k.a. “expensed”) for the first tax year. That leaves $487,179 that will be taxed at full income tax rates, assuming it was earned in the same year. Corporate income tax is currently about 40%, so that means the depreciation rules will cost the business $194,872 in additional tax in that crucial first year. And that’s after shelling out $500,000 to pay for the new building. The business is getting taxed on a cash outflow… you could even say it is getting taxed on an expense. Yes, the business owns the building, so it’s not an expense in the traditional sense. However, if the Cash Flow Method was allowed, the business would pay income tax when the building is sold. And they would actually have the cash at that point to pay the income tax.
What about Section 179 and Bonus Depreciation? Those help to reduce or eliminate the depreciation penalty, right? Yes, for certain types of equipment in certain situations, but not for real estate nor even improvements on real estate. While it’s great to have Section 179 in the tax code, it is only a temporary section that can be removed at any time. And as with any business-friendly rule in the tax code, it comes with many exclusions and qualifications, complicating that which should be simple.
Tax is a lot easier to pay after you receive money than it is after you just paid a lot of money. If you just drained your bank account on a major asset purchase, paying income tax on that asset purchase can be a bit difficult unless you saved for both the purchase and the tax; and most people don’t think about paying income tax on an asset purchase because it’s a hidden tax. The main point is that asset purchases should be treated as expenses and asset sales should be treated as revenue.
This is not about avoiding income tax. It’s about applying income tax appropriately only on cash inflows. So called “cash equivalents” (depreciation, accounts receivable, etc.) may have real value to a business and therefore should be included in determining net worth, but the U.S. Government does not accept payment of taxes in cash equivalents. Taxes can only be paid with cash. In a nutshell, depreciation and COGS fail in tax accounting because taxes cannot be paid with fixed assets or even non-cash liquid assets.