Depreciation is an accounting concept that business owners should be familiar with, especially for businesses that own vehicles or machinery. Understanding the basic principles of depreciation is key to evaluating how to account for the cost of purchasing assets on your books and tax return.
Depreciation is defined as “a reduction in the value of an asset with the passage of time, due in particular to wear and tear.” Essentially, calculating depreciation allows an accountant to track the value of an asset throughout its “useful life.” It also allows you to plan for the cost of an asset throughout its useful life rather than as a lump sum paid when the asset is originally purchased.
There are a few more terms it is important to define when exploring this topic.
“Depreciable assets” are tangible assets such as buildings, machinery, vehicles, and also intangible assets such as patents and copyrights.
“Useful Life” is the estimated period over which an asset is expected to generate economic benefits. This number is important when calculating depreciation.
“Salvage Value,” also known as residual value or scrap value, is the estimated value of an asset at the end of its useful life. This is subtracted from the initial cost of the asset to determine the depreciable base.
“Book Value” refers to the carrying value of an asset on the balance sheet. It is the initial cost minus accumulated depreciation.
There are several methods for calculating depreciation, an accountant should use the method that will be most beneficial to each particular client and their unique situation and assets. Some common methods are straight-line, declining balance, and units of production. Depending on the method used to calculate depreciation it will appear on a yearly budget as either a fixed or variable cost.
Regardless of the method, after completing calculations you will have a depreciation schedule. This schedule divides the cost of the asset across its estimated useful life which is incredibly useful for gaining a clear idea of the true cost of the asset measured against years of revenue associated with its use.
According to the IRS for an asset to be depreciable it must be owned by and used in the business to produce income, have a determinable useful life, and be expected to last for more than one year.
Machinery and equipment that costs less than $2,500 and/or assets used for less than a year are examples of non-depreciable assets. They get written off as an expense in the year they are purchased.
The IRS regularly updates their guidelines, so it is important to watch for changes in the rules and regulations surrounding this concept.
Depreciation and Taxes
Depreciation can reduce the taxes a business owes by tracking the decrease in the value of assets. Meaning this is a vital element in financial reporting, tax planning, asset management, and overall decision-making. It also allows organizations to align expenses with revenues, plan for asset replacement, and allocate costs over time.
Depreciation and Investment Analysis
Depreciation is also an important factor in evaluating the financial feasibility of long-term investments or capital projects. It should be considered when estimating net cash inflows from investments or projects over long periods of time.
Businesses and individuals who own and operate income-generating assets must have a solid grasp of this concept, or work with an accountant who does.