MACRS, or the modified accelerated cost recovery system, is the system of calculating tax deductions on depreciation in the United States. Under this, the manager assigns each fixed asset a specific asset class, which includes its useful asset life.
The modified accelerated cost recovery system is a standard depreciation method for most of the assets. It is because MACRS enables accelerated depreciation over longer periods. This benefits businesses as it allows them to deduct higher amounts during the first few years.
A Brief History
This system was introduced to push investment in depreciable assets through accelerated depreciation. MACRS meant more in terms of tax savings in the early years of depreciable life.
Under the Tax reform act of 1986, the ACRS (Accelerated Cost Recovery System) was modified and was given the name Modified Accelerated Cost Recovery System. At present, the United States taxpayers apply MACRS depreciation to asset class inclusive of office furniture, automobiles, computing equipment, construction assets, etc.
All the rules and schedules governing the Modified Accelerated Cost Recovery System depreciation appear in the US IRS Publication 946, “How to Depreciate Property.”
Depreciation is a non-cash expense and generally has a consequence on the firm’s accounts. As per the definition given by the Internal Revenue Service, depreciation is a deduction from the income enabling a business to recover the cost of a certain asset. This works in the form of an annual allowance the company gets from the deterioration or obsolescence of the property. As a general matter of fact, most tangible assets are depreciable. However, there are intangible assets such as copyrights and patents that are also depreciable.
Depreciation schedule has a significant impact on Financial Reporting. Every business reports the depreciable life of the assets in use. It is widely known that depreciation expense brings down the tax liability of the owner by reducing the reported earnings. Thus, under the accelerated depreciation method, the tax saving is much higher, resulting in higher returns than the straight-line depreciation.
Further, depreciation expense also brings down the asset book value by converting the part of the original asset purchase amount into an expense. Such an adjustment allows the owner to implement the accounting matching concept. Under the matching expense concept, a company records expenses as and when they incur them. Therefore, the deprecation expenses occur as and when the company uses the assets or there are wear and tear.
MACRS Vs. DDB Schedules
Normal DDB (Double Declining Balance) schedules differ from the DDB-based MACRS schedule in two ways:
The time of applying the depreciation on the assets is different in MACRS and normal DDB. Under the DDB method, one applies the depreciation expense at the start of the asset’s first year on the balance sheet. MACRS, on the other hand, applies depreciation expense at the midpoint of the asset’s first year on the Balance Sheet. Therefore, for an asset with five years of useful life, MACRS results in charging depreciation expenses in six tax years, starting from the midpoint of the first year to the midpoint of the sixth year.
Secondly, under MACRS, a business can change from the DDB method to the Straight Line depreciation after optimizing depreciation benefits.
Talking of similarities between the two, both the methods disregard salvage or residual value. This means the depreciation is applied against full asset cost. In simple terms, under DDB and MACRS, depreciation cost is equal to full asset cost.
Calculating depreciation under MACRS
There are two sub-systems under MACRS – General Depreciation System (GDS) and Alternate Depreciation System (ADS). Of the two, the General Depreciation System is commonly used for all assets.
Calculating depreciation under MACRS involves the following steps:
- First, identify the class of asset for which the company needs to calculate the depreciation expense. Usually, account managers classify properties into different categories depending on the useful life and recovery period. Also, the IRS lists the useful lives of various classes of assets to calculate depreciation. For instance, Information technology (IT) systems, including other kinds of office equipment and automobiles, have a five-year depreciable life.
- Second, the business would need to decide on the depreciation convention. For simplicity, the IRS has instructions on when to treat the asset as acquired in the mid of the month, quarter, or the year. Such conventions are mid-month, mid-quarter, and half-year conventions.
- The last step would be to decide on the depreciation method that one has to apply. Usually, account managers charge depreciation based on three different depreciation methods. i.e., 150% declining balance, 200% declining balance, and the straight-line method.
- Under the 200% Declining Balance Method (DBM), the rate is double the straight-line depreciation rate, resulting in a high tax deduction in the initial years. After initial years, the straight-line method comes into play when the earlier method results in an equal or greater deduction.
- Under the 150% Declining Balance Method, the rate is 150% more than the straight-line method. The depreciation method changes to a straight line when the earlier one results in an equal or greater deduction.
- Straight Line Method (SLM), as you will be aware, results in the same amount of deduction each year except for the first and last year of service.
Example of MACRS Calculation
Let us understand the calculation with the help of an example where a machine of $5,000 comes on Jan 1st.
First, we need to classify the asset. From the IRS classification of asset property, the machine is 7-year property.
Next, we have to select the depreciation method. As per IRS guidelines, it will be a half-year convention. Also, since it is a “nonfarm”7-year properties, we will use a 200% DB method.
Now, based on rates by IRS for 7-year property, we get the depreciation rate of 14.29% for the first year on a 200% declining balance.
In another example, a company buys a computer for $5,000 on April 1st. It is a five-year property, and the depreciation method is a Half-year convention. Since it is a “nonfarm” 5-year property, we will apply a 200% DB method. Using rates from the IRS, we get the depreciation rate of 20% for the first year.
MACRS may help businesses magnify their returns, but it is not advisable for audited financial statements. This method has got the approval from the IRS for tax reporting but not of GAAP for external reporting. This is because it ignores the asset’s useful life and salvage value. Therefore, businesses maintain separate books for tax accounting purposes.