8.1 Book vs Tax Depreciation, Capitalization & Cost Basis
Key Takeaways
- AIPB’s Certified Bookkeeper Part 2 includes a one-hour Prometric depreciation test; a 75% score is required on that test, separate from the payroll test in the same sitting.
- Book (GAAP) depreciation uses management estimates of useful life and salvage; tax depreciation uses Internal Revenue Code recovery periods, conventions, and methods covered in Chapter 9.
- Capitalized cost of a depreciable asset is invoice price plus freight, installation, and nonrecoverable taxes, minus purchase discounts; land is capitalized but never depreciated.
- Depreciable base for straight-line, units-of-production, and sum-of-the-years’-digits equals cost minus salvage (residual) value; declining-balance applies a rate to book value and does not subtract salvage up front, but stops at the salvage floor.
- Subsequent costs that add capacity or extend remaining life are capitalized; ordinary repairs and maintenance are expensed in the period incurred.
Why book depreciation is its own Prometric hour
The American Institute of Professional Bookkeepers (AIPB) tests depreciation as Test 2 of Part 2 at a Prometric center: one hour, passing grade 75%, fee bundled in the $100 Part 2 sitting. The official Mastering Depreciation workbook opens with book versus tax, then spends six sections on GAAP methods before MACRS. This OpenExamPrep chapter is independent study material for those GAAP topics. It is not an AIPB publication and does not claim official approval, review, partnership, or exact equivalence with AIPB, the Certified Bookkeeper exam, or any workbook.
Depreciation is the systematic allocation of a long-lived tangible asset’s cost to the periods that benefit from its use. It is not a valuation appraisal, a cash set-aside, or a tax election by itself. The credit is almost never to the asset account. It goes to Accumulated Depreciation, a contra-asset, so original cost stays visible and book value (carrying amount) equals cost minus accumulated depreciation.
Two computations exist for many U.S. small-business assets:
- Book (GAAP) depreciation for internal statements and for financial statements a CPA will compile or review. Useful life, salvage (residual) value, and method are estimates chosen to match expense to use.
- Tax depreciation for Form 4562 and the business return. Salvage is generally ignored, lives come from IRS class lives, and MACRS, Section 179, and bonus depreciation apply. Chapter 9 of this guide covers those tax rules. Do not paste a MACRS percentage table into a GAAP problem.
If statements must undergo a compilation or review, mixing tax depreciation into the books without labeling a special-purpose framework is a classic error. Management-use-only worksheets may track tax figures, but the GAAP fixed-asset subledger still needs a book method.
Capitalize what it takes to get the asset ready
Property, plant, and equipment (PPE) is recorded at historical cost: every reasonable and necessary outlay to acquire the asset and prepare it for its intended use, net of discounts. Harbor Kitchen Supply buys a commercial mixer on account:
| Cost element | Amount | Book treatment |
|---|---|---|
| Vendor invoice (list) | $40,000 | Include |
| Freight-in and rigging | $1,200 | Include — necessary to get the mixer on the floor |
| Installation, wiring, and test runs | $3,500 | Include — ready-for-use costs |
| Nonrecoverable sales tax | $2,800 | Include |
| Purchase discount taken | ($500) | Subtract — reduces cost, not miscellaneous income |
| Capitalized cost | $47,000 | Debit Equipment $47,000 |
Training the bakery staff, a separately billed extended warranty, and freight-out on goods the mixer later produces are not mixer cost. Insurance while the mixer is in transit is often added to cost; ongoing property insurance after it is in service is a period expense.
Basket (lump-sum) purchases allocate the single check among assets using relative fair values. Redwood Cabinet Co. pays $500,000 for land and a shop. Appraisals: land $150,000, building $450,000 (total FV $600,000). Land = 150/600 × $500,000 = $125,000. Building = 450/600 × $500,000 = $375,000. Only the building (and later land improvements) will be depreciated.
Contributed (donated) assets enter at fair value on the contribution date, not at the donor’s old book value. A used deck oven with a verifiable fair value of $8,400 is debited to Equipment for $8,400; the credit is contribution revenue (nonprofit) or paid-in capital / a gain (for-profit), depending on the entity. Subsequent depreciation uses that fair-value cost.
Group purchases of similar low-value items (a lot of identical chairs) may be capitalized as one asset with one life if the company’s capitalization policy allows it. The exam still wants the same cost-inclusion rules inside the group.
Land never depreciates; what sits on the land often does
Land has an indefinite life for book purposes. Do not take depreciation on the dirt, even if the company paid a premium for a corner lot. Costs that prepare land for its intended use — closing costs, grading, draining, and demolition of an old building the buyer does not intend to use — are added to land, not to a new building you construct later.
| Asset | Example | Depreciate? | Typical book life cue |
|---|---|---|---|
| Land | $80,000 lot under the warehouse | No | Indefinite |
| Land improvements | Asphalt parking lot $24,000, fencing, lighting | Yes | Shorter than the building; wears out |
| Building | Warehouse $360,000 | Yes | Long estimate (often decades) |
| Equipment / vehicles | Mixer $47,000, delivery van | Yes | Shorter operating life |
| Ordinary inventory | Flour on the shelf | No — not PPE | Expensed through cost of goods sold |
A parking lot is not land. A loading dock bolted to the building is usually part of the building. A movable packaging line is equipment. Getting the classification wrong either understates expense (parking lot parked in Land) or depreciates something that should last forever (land in Building).
Salvage, useful life, and depreciable base
Useful life is the period the company expects to use the asset, not the physical maximum years a manufacturer advertises. Salvage (residual) value is the estimated net amount after disposal costs at the end of that use. Both are estimates; both can be revised prospectively (Chapter 8.2).
Depreciable base for straight-line, units-of-production, and sum-of-the-years’-digits is:
Depreciable base = Cost − Salvage
Harbor’s mixer: $47,000 − $5,000 estimated salvage = $42,000 to allocate. Declining-balance methods are the exception you will compute in section 8.3: they apply a constant percentage to beginning book value and do not deduct salvage in the first formula, but they must not depreciate below salvage. Book value at the end of the planned life should rest on the salvage floor (or zero if salvage is zero).
Subsequent expenditures: capitalize versus expense
After the mixer is in service, cash still goes out. The test is whether the outlay adds future economic benefit beyond the original estimate.
| Outlay | Decision | Why |
|---|---|---|
| Quarterly oil, belts, and cleaning | Expense | Restores service potential; does not extend original life |
| Replace a burned motor and gain three extra years of use | Capitalize | Extends remaining useful life |
| Add a hopper that doubles batch size | Capitalize | Increases capacity |
| Repaint the housing the same color | Expense | Cosmetic maintenance |
| Rearrange the line without adding capacity | Expense (usually) | Does not improve the asset beyond original condition |
Capitalize by debiting the asset (or a clearly identified improvement account) so later depreciation uses the new book value. Do not debit Accumulated Depreciation for a betterment unless a textbook problem specifically uses the “reduce accum dep to extend life” presentation; AIPB-style items usually want a debit to the asset or to an improvement.
Journal entries and financial-statement geography
Nonmanufacturing (office, selling, general):
Dr Depreciation Expense 7,000
Cr Accumulated Depreciation—Equipment 7,000
Manufacturing (factory equipment): depreciation is a product cost. Debit Manufacturing Overhead (or Factory Overhead), not immediately a period expense. Overhead is allocated to Work in Process, then Finished Goods, then Cost of Goods Sold as units are sold. Parking a factory machine’s depreciation in Office Expense understates inventory and misstates gross margin.
On the balance sheet, PPE is typically shown at cost with accumulated depreciation deducted (or net of accum dep, with cost disclosed). On the income statement, nonmanufacturing depreciation sits in operating expenses. Depreciation is a noncash expense: the related cash left when the asset was purchased (or when principal is paid on the loan that funded it).
Realistic bookkeeper scenarios
Scenario A — tax numbers in the GAAP file. The owner wants “whatever the accountant used on the return” posted as the monthly book entry. You still maintain a book schedule with estimated life and salvage. Tax MACRS percentages belong on the tax worksheet (Chapter 9), not as a silent substitute when compiled statements are expected.
Scenario B — land plus demo. The company buys a lot with a condemned shed, pays $12,000 to raze the shed, and builds a new shop. The $12,000 is land, not building, because the shed was not placed in service by the buyer.
Scenario C — discount missed. Accounts payable recorded the $40,000 invoice and took a $500 discount when paying, crediting Miscellaneous Income. Cost is overstated by $500 and income is overstated by $500. Correct by reducing Equipment (and future depreciation) and reversing the income credit.
Traps
- Depreciating land, or burying a parking lot in the Land account
- Expensing freight and installation so year-1 “repairs” swallow the real cost
- Treating a purchase discount as income instead of a cost reduction
- Subtracting salvage in a declining-balance rate × cost setup on day one, then also applying the salvage floor
- Using IRS recovery periods as if they were GAAP useful lives
- Booking factory depreciation as a period expense in a manufacturer
Harbor Kitchen Supply buys a commercial mixer: invoice $40,000, freight-in $1,200, installation $3,500, nonrecoverable sales tax $2,800, and a $500 purchase discount taken. What amount should be capitalized as equipment cost?
Redwood Cabinet Co. records an $80,000 lot, a $24,000 asphalt parking lot, a $360,000 warehouse, and a $47,000 packaging line. Which amount is not depreciated on the GAAP books?
Northline Packaging replaces a burned conveyor motor, which engineering says adds three years of remaining use, and also pays the quarterly lubrication service on the same line. How should those two cash outlays be treated?