Depreciation…What is it?

Depreciation, a word usually associated with negative things; the wear and tear of your vehicle and it’s often misunderstood as a term for something simply losing value, or as a calculation performed for tax purposes. However, come tax time, you will thank depreciation for the tax savings it offers you for your capital assets.

WHAT EXACTLY IS DEPRECIATION?

Depreciation is the process of deducting the cost of a business asset over a long period of time, rather than taking the expense at one time. Depreciation has two main aspects. The first aspect is the decrease in the value of an asset over time. The second aspect is allocating the price you originally paid for an expensive asset over the period of time you use that asset.

The number of years over which an asset is depreciated is determined by the estimated useful life of the asset, or how long the asset can be used. For example, the estimate useful life of a laptop computer is about five years.

WHAT ASSET CAN BE DEPRECIATED?

Assets must meet the following criteria in order to be depreciated:

• The asset is owned by you

• The asset is used in the course of your business or to produce income

• You can determine the useful life of the asset

• The asset should last more than one year

Some examples of the most common types of depreciable assets include:

• Vehicles

• Buildings

• Office equipment

• Furniture

• Computers and other electronics

• Machinery and equipment

• Certain intangible items, such as patents, copyrights, and computer software.

TYPES OF DEPRECIATION

There are multiple methods of depreciation used in accounting. Here are the four widely used methods.

1. Straight-line depreciation

This is the simplest and most straightforward method of depreciation. It spreads an asset's value equally over its useful life, meaning you pay the same amount for every year of the asset's useful life.

Straight-line depreciation is a good option for small businesses with simple accounting systems or businesses where the business owner prepares and files the tax return.

The advantages of straight-line depreciation are that it is easy to use, it renders relatively few errors, and business owners can expense the same amount every accounting period.

However, its simplicity can also be a drawback, because the useful life calculation is largely based on guesswork or estimation. It also does not factor in the accelerated loss of an asset's value in the short term or the likelihood that maintenance costs will go up as the asset gets older.

• Depreciation formula: Divide the cost of the asset (minus its salvage value) by the estimated number of years of its useful life. The "salvage value" is the estimated amount of money the item will be worth at the end of its useful life.

• Here's what the formula looks like: (Cost of asset - Salvage value of asset) / Useful life of asset = Depreciation expense

2. Double-declining depreciation

This method, also called declining balance depreciation, allows you to write off more of an asset's value right after you purchase it and less as time goes by. This is a good option for businesses that want to recover more of the asset's value upfront rather than waiting a certain number of years, such as small businesses that have a lot of initial costs and are in need of extra cash.

The double-declining balance method is advantageous in that it can help offset increased maintenance costs as an asset gets older; it can also maximize tax deductions by allowing higher depreciation expenses in the early years.

However, if your business has already had a tax loss for a given year, you won't benefit from an additional tax deduction.

• Depreciation formula: 2 x (Single-line depreciation rate) x (Book value at beginning of the year). Or, you can use a double-declining calculator. The "book value" is the asset's cost minus the amount of depreciation you have already taken.

3. Sum of the years' digits depreciation

Sum of the years' digits (SYD) depreciation is similar to the double-declining method in that it is also an accelerated depreciation calculation. Instead of decreasing the book value, SYD calculates a weighted percentage based on the remaining useful life of the asset.

SYD suits businesses that want to recover more value upfront, but with more even distribution than they would otherwise get using the double-declining method. The SYD method's main advantage is that the accelerated depreciation reduces taxable income and taxes owed during the early years of the asset's life. The main drawback of SYD, though, is that it is markedly more complex to calculate than the other methods.

• Depreciation formula: (Remaining lifespan / SYD) x (Asset cost - Salvage value). You must first calculate the SYD by adding together the digits for each depreciation year. For example, the SYD calculation for five years is 5+4+3+2+1=15. You then divide each year by this sum to calculate that year's depreciation percentage. To find the percentage for the first year's depreciation, you would divide the digit of the first year (5) by the SYD total (15), which comes out to 33% (5 / 15 = 33%).

4. Units of production depreciation

This is a simple way to depreciate the value of an asset based on how frequently the asset is used. "Units of production" can refer to something the equipment makes — like the number of pizzas that can be made in a pizza oven, or the number of hours that it's in use. This method is good for businesses that want to write off equipment with a quantifiable and widely accepted (i.e., based on the manufacturer's specifications) output during its useful life. Make sure you have a method in place for tracking your use of equipment, and expect to write off a different amount every year.

The main advantage of the units of production depreciation method is that it gives you a highly accurate picture of your depreciation cost based on actual numbers, depending on your tracking method. Its main disadvantage, though, is that it is difficult to apply to many real-life situations, as it is not always easy to estimate how many units an asset can produce before it reaches the end of its useful life.

• Depreciation formula: (Asset cost - Salvage value) / Units produced in useful life

How does deprecation affect tax liability?

Depreciation reduces the taxes your business must pay via deductions by tracking the decrease in the value of your assets. Your business's depreciation expense reduces the earnings on which your taxes are based, which, in turn, reduces the taxes your business owes the IRS.  The larger the depreciation expense, the lower your taxable income.