How Do You Depreciate Business Assets?

How Do You Depreciate Business Assets?
As a small business owner, you are likely being inundated with processes, laws, and definitions you’re unfamiliar with—especially when it comes to handling your accounting. The term “depreciation” might sound familiar, we often use it to refer to a loss in value for cars, but in accounting, it has a very specific use. Depreciation is applied to properly attribute the expense of a long-term asset over several years and serves two distinct purposes. For your business’s accounting, depreciation shows how much of the asset’s value has been used in a specific accounting period, increasing net income and assets on your balance sheet. For tax purposes, depreciation is used to calculate how much you can write off each year for a business asset, reducing how much is owed. From figuring out how to classify your assets and which depreciation method to use, to ensuring your journal entries and taxes are recorded correctly, it can be easy to get overwhelmed by this topic. But don’t panic. A better understanding of depreciation will allow you to take advantage of this tool for your business and ensure you are in accordance with small business tax laws. Whether you do your own accounting or not, having at least top-level knowledge is important to protecting your business. Read through the entire article to explore the practice of depreciation from top to bottom or jump ahead to the section that best answers your question. What Types of Assets Can You Depreciate? Determining an Asset’s Useful Life Which Method of Depreciation Should You Use? How to Make a Depreciation Journal Entry How to Claim a Depreciation Deduction Advantages of Depreciation for Your Business We Can Help with Your Business’s Accounting & Taxes

What Types of Assets Can You Depreciate?

Depreciation is applied to tangible assets which only includes physical property that can be touched. Intangible assets are subject to amortization—a topic for another time. For example, a tangible asset would be a piece of equipment, whereas an intangible asset would be a patent. When determining which assets you can depreciate, you will need to refer to the IRS requirements. Depreciable property must:
  • Be something you own: Ownership can be determined if you possess a legal title, have an obligation to pay for the property, maintenance, operating expenses, or taxes on the property, or are at risk of loss if the property is damaged or diminished in value.
  • Be used by your business: The asset must be used in your business or activities that produce taxable income.
  • Have a determinable useful life: Over time, the asset must become worn, decayed, used up, obsolete, or lose value due to natural causes.
  • Be expected to last more than a year: If an asset will not last or be useful after a year of utilization, it must be expensed (another topic for another time) instead of depreciated.

Special Circumstances

It is important to note special circumstances that may apply to certain assets:
  1. If an asset is used for both business and personal needs, you can only depreciate a portion of the asset. In this case, it is imperative that you keep records that show how the asset has been used in different capacities.
  2. Assets that are low-cost are not typically eligible for depreciation. Instead, they should be recorded as an expense.
  3. Although you may think that land qualifies as a long-term asset, it does not lose utility over time so it is not eligible.
  4. While you cannot depreciate leased or rented property, you may be able to do so in regard to improvements you have made to the property.

Determining an Asset’s Useful Life

An asset’s useful life is defined from the time it is put into use at your business to when it’s retired from service. Useful life is always measured in years. The amount of time you are able to write off an asset depends on its useful life or the point you have fully recovered your cost. There are several factors to consider when trying to determine the useful life of an asset, including:
  • Predicted usage patterns
  • Age of the asset when you purchased it
  • Likelihood of technological advances that may render the asset outdated or useless
The IRS has established a General Depreciation System with nine classes to distinguish assets based on their useful life: Be sure to carefully consider each asset to ensure it is classified properly. Otherwise, it will be depreciated improperly and could affect your books and taxes.

Which Method of Depreciation Should You Use?

In addition to classifying your assets, you must determine which type of depreciation you will use. Depreciation methods are used to establish how the asset is written-off. The type of depreciation you’ll want to use will depend on the type of assets you’re expensing and your comfort level with the mathematics behind calculating annual depreciation.

1.   Straight-Line Depreciation

For beginners, the simplest form of depreciation is straight-line depreciation. With this method, the same amount is written off each year. You may also hear this method referred to as straight-line basis depreciation. This method of depreciation is typically used for assets that do not have a predictable usage pattern that would affect their useful life. Straight-line depreciation is calculated as follows:

Asset Cost – Salvage Value / Estimated Useful Life

Note: Since this is the first time we’re talking about salvage value, we’ll define it for you: Salvage value is the estimated value of an asset after it has been depreciated. In most cases, you will want to use a salvage value of $0. However, a greater salvage value is allocated to an asset when it is not going to be depreciated to $0. For instance, if you will be able to sell the asset or its parts when it is no longer useful to you.

Real-World Example

You purchased 20 computers for in-office use at your business. Your total for the computers was $20,500. Based on the General Depreciation System established by the IRS, these computers have a 5-year useful life. At the end of their useful life, the 20 computers will have a total salvage value of $4,000. Your straight-line depreciation equation would look like this: ($20,500 – $4,000) / 5 = $3,300 Then turn that into an annual percentage of depreciation: $3,300 / $20,500 = 16.1% So, you would be able to write off $3,300 (or 16.1% of the asset’s value) each year for the next five years.

Pros & Cons of Straight-Line Depreciation

Many small business owners choose the straight-line method because it is easy to use and lowers their risk of making errors. However, since the same value is spread out over time it does not protect the owner in the chance that the asset has a shorter useful life than predicted. This is often the case with technology. Due to this risk, it is often recommended that you pick and choose which assets you use the straight-line method for.

2. Double-Declining Depreciation

This depreciation method allows you to write off more of an asset at the front-end of its life. This is a concept known as accelerated depreciation. Double-declining depreciation is calculated as follows:

(2 x Single-Line Depreciation Rate) x (Book Value at Beginning of Year)

*Book value at beginning of year takes into account how much has been written off in the previous year(s).

Real-World Example

Continuing with the same example as before with 20 computers, here is how you would calculate double-declining depreciation: First, you’ll need to calculate the single-line depreciation rate:  ($20,500 – $4,000) / 5 = $3,300 You’ll then want to turn that into a percentage: $3,300 / $20,500 = 16.1% Next, use that number to calculate double-declining depreciation for each year of the asset’s useful life: Year 1: (2 x .161) x ($20,500) = $6,601 Year 2: (2 x .161) x ($13,899) = $4,476 Year 3: (2 x .161) x ($9,423) = $3,034 Year 4: (2 x .161) x ($6,389) = $2,057 Year 5: (2 x .161) x ($4,332) = $1,394 To check your calculations, your remaining amount of the original expense that has not been depreciated at the end of the asset’s useful life should be equal to the salvage value. Or, depending on how you’ve rounded your calculations, very close to it.

Pros & Cons of Double-Declining Depreciation

Double-declining depreciation should be used for assets that lose most of their value fairly quickly. By accounting for the greater portion of the expense earlier on, it will benefit you later when their are higher expenses for maintaining that asset, or it has lost much of its value. Typically, accelerated depreciation methods are recommended for technology. While double-declining depreciation is slightly more complex, it can help increase your cash flow which is especially important if you’re just getting your business off-the-ground. It will also allow you to maximize tax deductions while minimizing tax payments by offsetting profits, since they’re usually higher in the earlier years.

3.Sum-of-the-Year’s-Digits (SYD) Depreciation

Another form of accelerated depreciation, sum-of-the-year’s-digits (SYD) depreciation allows you to account for more of the asset’s depreciation up-front. SYD depreciation is calculated as follows:
  1. First you’ll need to calculate the sum of the digits of the asset’s useful life: (n = the estimated number of years of the asset’s useful life )

n(n+1) / 2

  1. Then, you’ll take the remaining estimated useful life in years and divide it by the sum of the digits of the
asset’s useful life to determine the applicable depreciation percentage for each year.

Remaining Estimated Useful Life / Total from the Above Equation

  1. Finally, to get the annual depreciation amount, you will multiply the applicable depreciation percentage
by the salvage value.

Applicable Depreciation Percentage / Salvage Value

Bear with us, we know this one’s tricky! The real-world example below will make things much clearer…

Real-World Example

For this example, let’s say the asset has a useful life of 10 years, was purchased at $100,000, and has a salvage value of $10,000. Step 1: Calculate the sum of the year’s digits. *Use this equation: n(n+1) / 2 10(10+1)/2 = 55 Step 2: You’ll calculate the applicable depreciation percentage for each year of the asset’s useful life. *Use this equation: Remaining Estimated Useful Life / Total from the Above Equation Year 1: 10/55 = 18.18% (this is the applicable depreciation percentage for the year). Year 2: 9/55 = 16.36% (*This time we used 9 instead of 10 years because there are only 9 years left in the asset’s useful life) And so on, all the way to year 10… Step 3: Calculate the annual depreciation in dollars for each year. *Use this equation: Applicable Depreciation Percentage / Salvage Value Year 1: $90,000 x 18.18% = $18,180 Year 2: $90,000 x 16.36% = $14,724 You’ll continue on with this calculation for each of the 10 years of the asset’s useful life so that you know the annual depreciation amount for each year. As you can see, the amount of depreciation is noticeably decreasing between years one and two. To check your calculations, you should add up the annual depreciation for all the years of its useful life (in this case, 10 years). This sum should be equal to the salvage value of the asset. When practicing the provided example, you would want it to equal $90,000.

Pros & Cons of SYD Depreciation

SYD depreciation is recommended for assets that have greater production capacity or usefulness in the first few years of ownership. Using SYD depreciation can complicate your cash flows because you’re reducing your taxable income significantly through lower profit reporting in the first few years of the assets useful life. Deferring your taxable income means that you will have larger tax bills in future periods.

4. Units of Production Depreciation

The units of production depreciation method is meant to be used for depreciating assets that fall under the category of “equipment”. A “unit of production” is either the output the equipment produces or the number of hours it’s used in operation. Units of production depreciation is calculated as follows: Step:1

Asset Cost – Salvage Value / Units Produced in Useful Life

OR

Asset Cost – Salvage Value / Hours in Operation over Useful Life

Note: This calculation gives you the depreciation cost per unit or hour. You will need to complete two more steps to calculate the amount of depreciation per year. Step 2: To figure out how much you can write off for the year, you will need to figure out how many units the assets outputs per year.

Units Produced in Useful Life / Asset’s Useful Life

OR

Hours in Operation over Useful Life / Asset’s Useful Life

Step 3: Finally, you can figure out the total depreciation cost for each year.

Depreciation Cost Per Unit x Number of Units Produced Per Year

OR

Depreciation Cost Per Hour x Number of Hours of Operation Per Year

Real-World Example

Let’s say you have a piece of production machinery that cost $100,000 and has a salvage value of $10,000. This piece of machinery should output 500,000 units during its useful life. The machine’s useful life is 5 years. Step 1: Calculate the depreciation cost per unit. $100,000 – $10,000 / 500,000 = $0.18 per unit Step 2: Calculate the number of units produced per year.  500,000 / 5 = 100,000 units per year Step 3: Calculate the depreciation per year. $0.18 x 100,000 = $18,000 per year Note: If the machine outputs a different number of units the second year and so on, you will need to adjust the units per year in the equation to get the correct annual depreciation value. This is usually the case, so the amount of depreciation for each year will be different.

Pros & Cons of Units of Production Depreciation

The units of depreciation method is meant to be used for equipment and makes it easy to account for differing production levels throughout the asset’s useful life. Since production capabilities are usually higher when the equipment is newer, it allows for larger tax deductions during these years. Using the units of production method for qualifying assets will also help you better track profits and losses that are tied to production. However, this depreciation method can only be used for certain assets like vehicles, printing machines, and other equipment that has a trackable output or hourly trackable usage rate. As such, it is not useful for all business owners, depending on the assets you use for your business activities.

How to Make a Depreciation Journal Entry

When creating a journal entry for depreciation of an asset, you want to abide by the matching principle. Basically, this means that there must be a debit and credit for the record. The journal entries for depreciation will include a debit entry to the depreciation expense account in the income statement and a credit entry to the accumulated depreciation account in the balance sheet. At the end of the period, the depreciation expense will be shifted to the accumulated depreciation account (which is carried over from period to period) and zeroed out for the next period.

Real-World Example

You purchased sophisticated 3-D printing equipment this year and it has an annual depreciation expense of $1,000. This is how you would complete the journal entry for that 3-D printer

How to Claim a Depreciation Deduction

To claim a depreciation deduction, you will use IRS Form 4562. You have two options when claiming a deduction for the value of an asset. You can use a depreciation deduction that will split the deduction over several years or a Section 179 Expense Deduction which allows you to deduct the full purchase price of the asset in the first year of ownership. Due to the Tax Cuts and Jobs Act, this deduction max’s out for a single asset at $1,000,000 as of 2019. Additionally, you can only purchase $2,500,000 in equipment in a given year. This simply means that you must not spend more than $3,500,000 on equipment within the year. This is meant to ensure that this deduction exclusively serves small businesses. When completing your small business taxes, consider which type of deduction will best suit your cash flow needs.

Advantages of Depreciation for Your Business

As we’ve mentioned, there are several important advantages for businesses that depreciate assets: From how you run your business to the entity’s financial health, depreciation is a tool you can use to make the most of your tangible assets and reduce your losses. Some of the most notable benefits of depreciating asset expenses include:
  1. Reliable Financial Information: Applying depreciation when reporting the use of an asset on your financial records helps to ensure that they reflect an accurate net income. If the entirety of the asset was expensed in the first year, it would distort these numbers. Having accurate financial information to refer to is important for you and your stakeholders when planning future investments.
  2. Cost Recovery: By depreciating the expense of an asset, you can set aside a portion of revenues to replace that asset once it has reached the end of its useful life.
  3. Lower Taxable Income: Using a higher depreciation expense as a deduction on your taxes lowers your taxable income. This means a tax savings!
Don’t be deterred from depreciating your assets because it sounds difficult. Our financial experts can help walk you through the types of depreciation or simply perform these duties on your behalf so you can focus on the many other responsibilities on your to-do list. We’re here to make your job easier.

We Can Help with Your Business’s Accounting & Taxes

While running your business may be all on your shoulders, figuring out how best to approach your small business accounting and taxes doesn’t have to be. The experts at Community Tax are well-versed in the nuances that affect small businesses and their bottom line to help you make the best decisions. Working with our team will help you ensure that your bookkeeping is done correctly throughout the year, including depreciating your assets, and when it comes time to file your taxes, we can file everything on your behalf so your business remains in good standing with the IRS.