At its core,
the concept of depreciation is simple: When a business buys a fixed asset, a long-term asset used in the production of inventory, which is then sold for a profit, it commits to keeping the asset on their books and in their tax returns for years to come. The cost of the asset must be allocated over the course of its useful life, since it continues to generate value for the company up until the point it is disposed.
Asset Depreciation is the means for businesses to write off the cost over that time.
THE BASICS
Examples of
fixed assets include land, buildings, vehicles, laptops, computer software, furniture and warehouse or office equipment, all things that will likely last more than a year, but not indefinitely. Of those assets, the ones that deteriorate or otherwise become obsolete (land, for example, does not lose value over time since it should theoretically last indefinitely) must meet a certain set of criteria in order to be depreciated,
according to the IRS:
- The taxpayer must own the property or asset (capital improvements to leased property fall under this rule).
- The asset must be used in business or in an income-producing activity. if this asset is also used at home, only a portion of the asset may be depreciated.
- The asset must have a useful life longer than one year; if placed in service and disposed of in the same year (i.e. office supplies like pens, as opposed to an office copier).
Perhaps the most
important aspect of the depreciation process is determining and executing the proper depreciation method. Once you account for a planned
salvage value (the value of the asset once its useful life is over), settle on a useful life as per IRS or local tax guidelines and determine what method you’ll be using (as A salvage value could be a small amount that you’ll sell the asset for, or perhaps zero or negative)
Businesses
choose a depreciation method based on what will best match the revenue
the asset will help generate. If you expect the asset to have the same efficiency over the course of its life, a standard method is suitable. If the asset will generate more revenue in its early years, an accelerated method can reflect that. The most common depreciation methods fall into those two categories.
STANDARD
Straight line depreciation: This is the most often used and simplest of the depreciation methods. It means the asset depreciates by the same amount every year until the cost has been fully allocated. Using the straight line method, the annual depreciation expense is the cost of the fixed asset (minus its salvage or residual value) divided by the useful life the asset, in years. There are variations on straight line depreciation, see below.
ACCELERATED
Declining balance: In this accelerated method, more of the depreciation expense comes in the early years of the asset’s useful life. Using a factor, the company multiplies the asset’s supposed straight line depreciation calculation by that factor. This often result in a doubled depreciation rate. A
double declining balance uses the same formula as the declining balance, but that rate is doubled again.
Sum of the years digits: Typically even more accelerated than a declining balance method, here the sum of years of the asset’s useful life creates a factor. For example, a machine with a five year life span has a factor of 15 (5+4+3+2+1). Then a fraction is created using this factor as the denominator and the remaining actual life expectancy as the numerator. In this example, in year one the depreciation would be 5/15, or ⅓. The following year would be 4/15, the third year would be 3/15, and so on.
VARIATIONS
While there are variations on these methods (such as the
group depreciation method, which is used to depreciate multiple-asset accounts of the same nature using a straight line method), there are also less commonly used practices, some of which are based on the level of use of the asset, rather than simply the passage of time. They include:
Units of production: Here the useful life of the asset is expressed in terms of the total expected produced units. If an asset produces a certain number of units, or products, or inventory per year, that number is used to divide the original cost to find the depreciation expense.
Units of time
Similar to units of production, this method is used when the amount the asset is used isn’t consistent from year-to-year. If an asset is used for a specific purpose in each project, and the number of projects is variable, depreciation will be charged according to that sporadic use.
DEPRECIATION IN ACTION
Depreciation can actually take different forms:
book depreciation and tax depreciation. Book depreciation expense is the amount recorded in the company’s financial statements. It is based on the “matching principle” of accounting, requiring the asset’s cost to be allocated to depreciation expense over the life of the asset. Tax depreciation is calculated and appears on the company’s income tax returns and must adhere to IRS tax codes and regulations.
Thus, a company can have two completely different depreciation methods, calculations and numbers on its books and in its tax returns, particularly if IRS rules dictate that a certain machine has a useful life longer than what the company plans to use it for. The company uses straight line depreciation for its own records and an accelerated method for official tax documents to compensate.
Depreciation, sometimes calculated, is done for accounting purposes and doesn’t involve any actual exchange of money after the asset has been purchased. It is, however, an expense, and it decreases the company’s taxable income. By decreasing that income, the amount owed in taxes decreases as well. This is a big part of choosing a depreciation method: An accelerated method, for example, reduces income in early years, but as time goes on, the amount of depreciation (and thus tax benefit) allowed is reduced.
At the end of the day, depreciation is not just a recommended practice for businesses large and small, it’s a requirement. Companies must stick to when depreciating for their tax returns, and keep accurate books in order to reduce the stress that auditing fixed assets can have on your employees. In the modern era, most viable businesses have begun using
asset tracking and management software to calculate and record the depreciation of all their assets. Doing so can turn a requirement into a financial advantage over competitors who insist on bogging down their workflow with outdated solutions.
