Depreciation: Here’s What Every Business Needs To Know About it - Part I

As a business owner, it is always good to know all the legal ways you can save in taxes, that is why we want to introduce you to Depreciation, an extensive yet helpful method that will reduce your Tax Liability.

Let’s start by saying that Depreciation is an accounting method of allocating the cost of a tangible or physical asset over its useful life or life expectancy. It represents how much of an asset's value has been used up. By depreciating assets you help your business earn revenue from an asset while expensing a portion of its cost each year the asset is in use. If not taken into account, it can greatly affect profits.

Your business can depreciate long-term assets for both tax and accounting purposes. For example, you can take a tax deduction for the cost of the asset, meaning it reduces taxable income. However, the Internal Revenue Service (IRS) states that when depreciating assets, you must spread the cost out over time. The IRS also has rules for when you can take a deduction.

How Depreciation Works?

Depreciation allows you to recognize this by writing off their costs over time. You can expense a portion of an asset’s value each year it’s used, or even deduct the entire amount at once. It depends on whether you’re using depreciation for tax or accounting purposes.

How to calculate Depreciation?

There are several methods to calculate it, including straight line basis, declining balance, double declining, units of production, and sum-of-the-years’ digits, all with different advantages and disadvantages that we will be explaining in a series of posts, so stay tuned.. Today, we want to show you the two main ones:

1. Straight Line Basis

Or straight-line depreciation, depreciates a fixed asset over its expected life. In order to use the straight-line method, taxpayers must know the cost of the asset being depreciated, its expected useful life, and its salvage value; the price an asset is expected to sell for at the end of its useful life.

Example: suppose you buy a production machine for $30,000, the expected useful life is 3 years, and the salvage value is $3,000.

MachineUseful LifeSalvage Value Depreciation Yearly

$30,000 3-years $3,000

The depreciation expense for the production machine is $9,000: ($30,000 - $3,000) ÷ 3, per year.

2. Declining Balance

This method applies a higher depreciation rate in the earlier years of the useful life of an asset. It requires to know the cost of the asset, its expected useful life, its salvage value, and the rate of depreciation.

Example: suppose you buy a fixed asset that has a useful life of three years; the cost of the fixed asset is $5,000; the rate of depreciation is 50%, and the salvage value is $1,000.

To find the depreciation value for the first year, use this formula:

Year 1

(net book value - salvage value) x (depreciation rate).

The depreciation for year one is $2,000: ([$5000 - $1000] x 0.5).

Year 2

(net book value - salvage value) x (depreciation rate).

The depreciation is $1,000: ([$5000 - $2000 - $1000] x 0.5).

Year 3

(net book value at the start of year three) - (estimated salvage value).

In this case, the depreciation expense is $1,000 in the final year.

It is really important to understand that the Depreciation and Amortization works alike, however the assets differ. Amortization charges off the cost of an INTANGIBLE ASSET, while depreciation does so for a TANGIBLE ASSETS.

Another difference between Depreciation and Amortization is that Amortization is almost always conducted on a straight-line basis, so that the same amount of amortization is charged to expense in every reporting period. Conversely, it is more common for Depreciation expenses to be recognized on an accelerated basis, so that more depreciation is recognized during earlier reporting periods than later reporting periods.

In our next post related to depreciation we will show you how to use depreciation for tax purposes and other interesting tips. Stay tuned!