Calculating and Reporting Revised Depreciation

Depreciation is an annual allowance for the wear and tear, deterioration, or obsolescence of property used in a trade or business or for the production of income. When an asset is first placed in service, a business establishes a depreciation schedule based on its cost, estimated useful life, and salvage value. This initial calculation, however, is not always permanent. Throughout the operational life of an asset, new information or the discovery of a past error can require a business to revise its depreciation expense. Making these revisions correctly is necessary for accurate financial records and tax compliance.

Triggers for Revising Depreciation

The reason for a depreciation change dictates the entire process, from calculation to reporting. The Internal Revenue Service (IRS) distinguishes between two primary triggers: a change in accounting estimate and a change in accounting method. Misclassifying the trigger can lead to incorrect filings and potential penalties.

A change in accounting estimate is a forward-looking adjustment based on new information that affects the asset’s future use. For example, if a piece of machinery is proving to be more durable than originally anticipated, its useful life might be extended. Similarly, if market conditions suggest the asset will be worth more or less at the end of its life, its salvage value would be revised.

A change in accounting method, conversely, is a correction of a mistake made in a prior year when depreciation was calculated using an impermissible approach. An example is using the straight-line method for an asset that tax law, such as the Modified Accelerated Cost Recovery System (MACRS), requires to be depreciated differently. Other errors include failing to claim any depreciation or incorrectly classifying an asset’s recovery period. Once an accounting method has been used, even an incorrect one, a taxpayer must generally request permission from the IRS to change it.

Calculating the Revised Depreciation Amount

After identifying the trigger for the change, the next step is to compute the new depreciation amount. For a change in accounting estimate, the adjustment is applied prospectively, affecting only current and future tax years without altering prior depreciation. The new annual depreciation is found by taking the asset’s current book value (original cost minus accumulated depreciation) and subtracting the newly revised salvage value. This result is then divided by the asset’s remaining useful life.

For instance, consider a machine purchased for $50,000 with an initial 10-year life and a $5,000 salvage value. After three years, $13,500 in straight-line depreciation has been taken, leaving a book value of $36,500. If new information suggests the asset will now last for a total of 12 years (nine years remaining) and have a salvage value of $2,000, the calculation changes. The new annual depreciation would be ($36,500 – $2,000) / 9, which equals $3,833 for each of the remaining nine years.

When correcting an accounting method, the process involves a “catch-up” calculation known as a Section 481(a) adjustment. This adjustment reconciles the difference between the depreciation that was taken and what should have been taken. The first step is to recalculate the total depreciation from the asset’s placed-in-service date up to the beginning of the current year using the correct method. From this total, you subtract the actual depreciation that was claimed over the same period. The resulting figure, which can be positive or negative, is the Section 481(a) adjustment.

Reporting Changes to the IRS

The final step involves communicating the revised depreciation to the IRS. For a change in accounting estimate, no special permission or separate form is required. The newly calculated annual depreciation amount is simply reported on the appropriate line of Form 4562, Depreciation and Amortization, for the current tax year.

Reporting a change in accounting method is a more formal process that requires filing Form 3115, Application for Change in Accounting Method. This form must be completed and attached to the taxpayer’s timely filed federal income tax return for the year the change is being made. The form requires:

• The taxpayer’s identifying information
• A description of the incorrect method being changed
• A description of the new, correct method
• The calculated Section 481(a) adjustment

For many common depreciation-related changes, such as correcting an impermissible method, the IRS provides an automatic consent procedure. This means the taxpayer does not need to wait for explicit IRS approval or pay a user fee before implementing the change, provided Form 3115 is completed correctly and filed with the return. A negative Section 481(a) adjustment is generally deducted in full in the year of the change, while a positive adjustment is typically spread over four years.