GAAP vs. IRS Depreciation Methods

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GAAP is the set of Generally Accepted Accounting Principles used by businesses in the United States. All public companies are mandated by the Securities and Exchange Commission (SEC) to use GAAP, even though GAAP is not written into US law. Straight-line depreciation, under GAAP, is a standard accounting procedure when calculating corporate financial statements for auditing purposes. However, for tax purposes, the IRS requires companies to follow the Modified Accelerated Cost Recovery System (MACRS) when calculating asset depreciation, resulting in a fully depreciated asset resulting in a book value of zero.

History of Depreciation Accounting

The Financial Accounting Standards Board (FASB), structured in 1973 with auditors taking a primary role in establishing accounting principles, is the authority in creating GAAP for businesses in the United States. In 1986 MACRS (pronounced "makers") replaced the Accelerated Cost Recovery System (ACRS), established in 1981 under President Reagan's Economic Recovery Tax Act. MACRS was a new depreciation philosophy for the purposes of taxation, which ignore "useful life" and "salvage value" traditionally associated with property valuations under ACRS and GAAP. This simply illustrates the difference between GAAP accounting, which is focuses on a company's valuation versus determining a company's tax liability, which is the purpose of MACRS.

Straight-Line Depreciation

According to the IRS, depreciation is an income tax deduction allowance that provides tax payers the ability to recover the cost of a property and is based on an "annual allowance for the wear and tear, deterioration, or obsolescence of the property." Most types of tangible property (except land), including buildings, furniture, machinery, and equipment are depreciable. Depreciable intangible property includes patents, copyrights and software. Under straight-line methods, a property's value is depreciated at a constant dollar value per year over its expected life span.

Modified Accelerated Cost Recovery System (MACRS)

The MACRS depreciation model is used for calculating business income taxes and not determining the value of a company. Under this depreciation regime the asset depreciation calculation is based on a staggered formula, whereupon asset classes are designated a life span, such as automobiles and light trucks, whose useful life cycle is 5 years. Then, a certain percentage depreciation allowance is assigned to each year, as given in MACRS depreciation tables. This formula depreciates the asset to zero, with no residual or "salvage" value associated with the asset. For instance, a company that acquires an asset for $250,000 may, under GAAP rules, determine the asset has a residual value of $50,000 after depreciation. However, IRS rules under MACRS assumes the residual value is $0.00.

GAAP Versus IRS Depreciation

The fundamental difference between GAAP and IRS depreciation taxation calculations is that MACRS is required by the IRS, whereas GAAP is demanded by government agencies like the SEC for auditing purposes because it provides a standard measurement. For auditing purposes straight-line depreciation methods are required under GAAP rules. Other differences are that, under MACRS a company is able to depreciate more of the capital costs, such as plant, equipment and machinery, in the early years of the property's life span. Whereas, GAAP rules under straight-line depreciation methods do not catch up to MACRS until the fourth year on a 5-year depreciation cycle. Finally, under certain circumstances, small businesses are able to depreciate equipment purchases completely in the first year.