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Depreciation is an accounting practice that spreads out the cost of a business asset purchase over the asset’s expected lifespan. Instead of the asset purchase appearing as a large financial loss in a single year, depreciation can improve a company’s income statement and balance sheet while also spreading out tax benefits.
Find out how depreciation works, two common methods used in accounting to calculate it, and how it impacts your business taxes.
Key Points
• Depreciation is an accounting method that spreads out the purchase price of a physical asset over its useful life.
• Through depreciation, accountants can help prevent a large drop in a company’s financial statements after it purchases a significant physical asset.
• You can calculate depreciation as straight-line depreciation, which distributes the cost evenly over time, or accelerated depreciation, which starts with larger amounts and then diminishes over time.
• Depreciation can also be used to distribute tangible asset costs over time for tax deduction purposes.
Depreciation Definition
What does depreciation mean? It’s a small business accounting method that spreads out the cost of an asset each year over its lifespan. This timeline is called its useful life, and the value of the asset also accounts for the ongoing wear and tear. Depreciation’s definition only applies to physical assets that lose value over time, such as equipment, machinery, or vehicles. It doesn’t apply to personal property, business inventory, or land.
The purpose of depreciation is to help companies avoid what looks like a large loss on their balance sheets after making a major purchase. This can be particularly important when it may take time for that purchase to contribute to revenue growth. It can help companies budget for when they’ll need to make another large purchase to replace the asset. Depreciation can also be used when calculating a tax deduction for a tangible business asset.
Depreciation vs Amortization
Depreciation is similar to amortization in that both are accounting methods used to deduct the cost of an asset over its useful life. Both can also be used as business tax deductions. The key difference is the type of asset each method is used for.
Depreciation applies to tangible assets, such as business vehicles, technology, or furniture. Amortization, on the other hand, applies to intangible assets like patents or lease agreements.
Additionally, you can only use the asset’s resale value with depreciation, rather than the full purchase amount. While depreciation lets you choose between a straight-line and accelerated accounting method, you lose that flexibility with amortization, which only allows the straight-line method to be used. (We’ll delve deeper into these methods shortly.)
How Depreciation Works in Accounting
Once you calculate a physical asset’s depreciation for the year, it’s listed as an expense on your business income statement. You can still depreciate an asset even if you use equipment financing for the purchase. The asset’s value, debt incurred to purchase it, and depreciation amount are all listed on the small business balance sheet.
Depreciated assets are grouped into different categories based on the expected length of their useful life. These categories include 3-year, 5-year, and 7-year assets. The 3-year category applies to heavy machinery; 5-year property applies to office equipment and vehicles; and 7-year property applies to office furniture and appliances.
Companies often create a minimum threshold for using depreciation based on their size. A smaller business, for instance, would choose to depreciate assets with a lower purchase price, while larger companies may have a higher threshold since a smaller purchase wouldn’t offset revenue as much.
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Common Depreciation Methods
Two of the most common depreciation methods in accounting include straight-line depreciation and accelerated depreciation. For both formulas, you’ll need to determine the asset’s useful lifespan, which is sometimes included in the manufacturer specifications.
Straight-Line Depreciation
Straight-line depreciation spreads out the total cost of the asset evenly throughout its useful life.
The formula for straight-line depreciation is:
(Asset Cost – Expected Salvage Value) / Years of Useful Life = Annual Depreciation Amount
The asset cost is the purchase price, and the expected salvage value is how much the asset will be worth by the end of its useful life.
For the first year, you only deduct the portion of the annual depreciation amount corresponding to the number of months you use the asset. So if you purchased a company vehicle in June, the business would only use it for seven months of the year. You would then multiply your annual depreciation deduction by 7/12 to get the right proportion for the first year, then start deducting the full amount moving forward.
The benefit of using the straight-line method is that it spreads out the expense evenly, making your financial statements more stable. The drawback is that you’ll receive a smaller tax deduction earlier on than if you used accelerated depreciation.
Accelerated Depreciation
Accelerated depreciation lets you depreciate assets at a faster rate than the straight-line method by prioritizing larger deduction amounts early on.
Here is the formula using the double declining balance method of accelerated depreciation.
2 x Straight-Line Depreciation Rate x Book Value at the Beginning of the Year = Annual Depreciation Amount
This option lets you use the depreciation expense as a larger tax deduction in the early years. But that also means the deduction gets smaller over time.
Depreciation Examples by Asset Type
Here are some common types of assets, their typical useful life, and examples of purchases a company may make within each category.
| Example Asset Depreciation | ||
|---|---|---|
| Asset Type | Typical Useful Life | Common Examples |
| Technology | 3 to 5 years | Computers, tablets, POS systems |
| Vehicles | 5 years | Company cars, vans, trucks |
| Furniture | 7 years | Desks, chairs, conference tables, safes |
| Equipment | Up to 20 years | Manufacturing equipment, tools, machinery |
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How Depreciation Affects Taxes
Depreciation also applies to taxes, not just company financials. When you depreciate an asset on your company financials, you may be able to use it as a small business tax deduction in Section 179. The IRS provides guidance on what types of property depreciation can be used for as a tax write-off, which includes:
• The business must own the property (even if it’s financed)
• Must be used in an income-producing activity
• Must last more than one year
Additionally, you can’t take a deduction once the asset is out of service, even if you didn’t deduct its full value over time.
The Takeaway
Depreciation can help your business invest in major assets without worrying as much about the impact on your profitability figures. Additionally, depreciation expenses can be used as a tax deduction, lowering your overall burden over the course of each item’s useful lifespan.
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FAQ
What assets can be depreciated?
Physical assets can be depreciated, including technology, vehicles, furniture, and equipment.
How does Section 179 depreciation work?
Section 179 is the portion of the tax code that allows you to deduct eligible depreciation expenses from a company’s taxes. To qualify, the depreciated asset must be owned by the company, used for more than one year, and used for income-producing activities.
What is the difference between book depreciation and tax depreciation?
Book depreciation’s meaning is the depreciation listed in a company’s financial statements, while tax depreciation is the figure listed as an expense to get a deduction.
How does depreciation affect a company’s financial statements?
Depreciation affects a company’s financial statements by acting as an expense. This impacts the business’s income, but also helps spread out a large expense for a more balanced statement.
Can real estate be depreciated?
Yes, real estate owned by the business can be depreciated, but the land it sits on cannot.
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