Book vs. Tax Depreciation Methods in the Construction Industry

Plant, Property and Equipment (PP&E) is a vital component to most construction contractors’ operations, specifically for heavy equipment contractors and subcontractors. Outside of human capital, it is often the most important resource for contractors to complete their work on hand and compete for future work. PP&E also makes up a large portion of many contractors’ balance sheets and is subject to management estimates in the form of depreciation methods and useful lives. As these vary from contractor to contractor and often have a large impact on a bonding company’s view of your overall financial position (bonding capacity), it is important to understand the key book/tax depreciation differences and their implications on a company’s financial statements.

Book Methods

Book depreciation methods are set based on management’s estimate of the PP&E’s useful life and residual value. This estimate can be derived from historical experience with similar classes of assets or using published equipment guides and is typically documented in a capitalization policy. Generally Accepted Accounting Principals (GAAP) allow for straight-line and accelerated depreciation methods for book purposes; however, depreciation will occur over the asset’s useful life. GAAP also allows management to estimate the residual value of an asset at the end of its useful life. The residual value represents the scrap/salvage value that assets have at the end of their useful life.

Tax Methods

Contrary to book methods, tax methods are set by Congress and are subject to changes in tax legislation. Current tax law is very favorable and allows for a company to immediately expense qualifying PP&E in the year of acquisition through bonus or section 179 depreciation.

Bonus depreciation is not limited at the taxpayer level and allows for 100% of an asset’s cost to be taken as an expense in the year of acquisition. Bonus depreciation begins to phase out after the 2022 tax year with a full phase-out of 20% each tax year through 2027.

Section 179 depreciation is limited at the taxpayer level and allows for 100% of an asset’s cost to be taken as an expense in the year of acquisition. While no scheduled phase-out is anticipated, section 179 depreciation is limited on an annual basis at the individual and entity level.

Financial Statement Implications

Many pitfalls exist related to depreciation, with certain examples provided below:

• Utilizing tax methods for internal financial statement purposes – Will result in understated profitability and equity.
• Omitting residual value from large PP&E – Will result in understated equity and large gains on disposal.
• Failing to record depreciation and disposals on a regular basis – Will result in significant swings in profitability throughout the year.

Overall, it is important to understand the needs of the users of the financial statements and work with your Lutz representative to ensure that these needs are met. Properly evaluating your PP&E strategy can help mitigate tax, bonding, and banking issues and ensure the business has the appropriate level of PP&E on hand while not creating unintended consequences.

If you have any questions or would like more information on this topic, please contact us today. You can also learn more about our construction accounting services here.