What Is Depreciation?
If you own your own business, you’ve probably heard the term depreciation before, but you might not understand exactly what it is, or how it’s calculated. When it comes to managing your business taxes, depreciation is an important concept, so our tax advisory experts have prepared this guide. Read on to get the scoop on depreciation and why it matters to you!
What Is Depreciation, and How Can You Use it to Your Advantage?
Deprecation is an accounting method that allows you to spread the cost of a physical (tangible) asset over the cost of its useful lifetime. Essentially, depreciation represents how much of an asset’s value has been used. Because you don’t have to account for the entire cost of the asset in the year it is purchased, it helps reduce the immediate cost of ownership. Therefore, using depreciation effectively can help manage your costs and income, allowing you to manage your taxes more efficiently.
What Qualifies as a Depreciable Asset?
A depreciable asset is a physical asset purchased for your business that is eligible for depreciation based on IRS Publication 946. Requirements include:
- You must be the owner
- You must use it in your business or income-producing activity
- It must have a useful life of at least a year
What Are Some Examples of Depreciable Assets?
Examples of depreciable assets include tangible assets such as:
- Computer and other equipment
- Office buildings
- Buildings you rent out for income (both residential and commercial property)
What Are Some Examples of Non-Depreciable Assets?
Examples of non-depreciable assets are:
- Current assets such as cash and receivables
- Investments such as stocks and bonds
- Personal property that is not used for business
- Leased property
- Collectibles such as art and coins
How Do You Account for Depreciation?
When you purchase an asset, you record the transaction as a debit to increase an asset account on your balance sheet and a credit to reduce cash (or increase accounts payable). Neither journal entry affects your income statement, where revenues and expenses are reported.
At the end of an accounting period, you book depreciation for all capitalized assets that are not fully depreciated. The journal entry consists of a:
- Debit to depreciation expense, which flows through to your income statement
- Credit to accumulated depreciation, which is reported on your balance sheet
Are There Different Types of Depreciation?
There are several different depreciation methods that accountants use. These include straight-line, declining balance, double-declining balance, sum-of-the-years’ digits, and unit of production. You can see a summary of each depreciation method below:
Straight-line depreciation is the most straightforward method of depreciating an asset. In this method, you simply divide the value of the asset by its useful life, and report an equal depreciation expense each year throughout that life. For example, if an asset is purchased for $1,100 and has a 10 year useful life and a salvage value at the end of its life of $100, you would subtract $100 from $1,100 to get a depreciable amount of $1,000. Then you would divide that $1,000 by 10 to get $100 per year. So your depreciation expense each year—using the straight-line method—would be $100.
Declining Balance Depreciation
The declining balance method allows you to accelerate your depreciation more quickly in the early years, and slow it down in later years. This method writes down the cost of the asset at its straight-line depreciation percentage times its remaining depreciable amount each year. An asset’s carrying value is higher in earlier years, so the same percentage causes a larger depreciation expense amount in earlier years, declining each year.
The formula for calculating declining balance depreciation is:
(Net Book Value – Salvage Value) x (1 / Useful Life) x Depreciation Rate
Using the same example above, the asset costs $1,100, has a salvage value of $100, a ten-year life, and is depreciated at 10% each year, so the expense is $100 in the first year ($1000 x 10%), then $90 the second year (($1000-100) x 10%)), then $81 the third year (($1000-190) x 10%)), and so on.
Double-Declining Balance (DDB) Depreciation
The double-declining balance (DDB) method is another method that allows you to accelerate depreciation. In fact, it is essentially twice as fast as the standard declining balance depreciation method. The formula for DDB depreciation is:
(Net Book Value – Salvage Value) x (2 / Useful Life ) x Depreciation Rate
For example, our asset with a useful life of ten years would have a reciprocal value of 1/10, or 10%. Double the rate, or 20%, is applied to the asset’s current book value for depreciation. In year one, the depreciation amount would be $200 (double the straight-line depreciation amount for the first year). In the second year, the depreciation would be $160 (($1,000 – $200) x( 2×10%)), and so on.
Sum-of-the-Years’ Digits (SYD) Depreciation
Another accelerated depreciation method is called the sum-of-the-years’ digits (SYD) method. In this more complicated method, the calculations start by combining all the digits of the expected life of the asset. For example, our asset with a ten-year life would have a base of the sum of the digits one through ten, or 1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 + 9 + 10 = 55. In the first depreciation year, 10/55 of the depreciable base would be depreciated. In the second year, 9/55 of the depreciable base would be depreciated. This continues until year ten depreciates the remaining 1/55 of the base.
Units of Production Depreciation
The final method of depreciation we will discuss is the units of production method. This requires estimating the total units an asset will produce over its useful life, and then calculating each year’s depreciation expense based on the actual number of units produced that year.
How Is Depreciation Different From Amortization?
Depreciation is a term that refers to physical assets or property—items that are tangible. Amortization is an accounting term for the method of writing down the value of intangible assets such as intellectual property or loan interest over time.
Depreciation in Summary
Depreciation allows you to spread the cost of tangible assets over the useful life. It can be an important tool for tax planning, so it’s helpful for business owners to understand how to properly account for depreciation. If you need personalized help from experts who specialize in helping you optimize your taxes, reach out for a free consultation with a Prime advisor—we’re here to help!