As a small business owner, account management is pivotal for you to maintain a steady financial portfolio. That’s why following an accurate accounting system is a norm among business owners. The system matches expenses and revenue, allowing the business to run smoothly.
To ensure the expenses match with the revenue, you need to be thorough. Buying an asset means the cost can be deducted as an expense. But tax regulations dictate that your business must spread the expense throughout the asset’s lifetime.
This process is called depreciation and helps businesses maintain a comprehensive overview of revenue generation. While the concept is common, you might not have understood it yet. This guide dives into everything you need to know about depreciation to help you out.
Depreciation can be defined as the systematic value reduction of a fixed asset over its useful lifetime. An example of fixed assets can be office equipment, machinery, building, etc. While land is also a fixed asset, its value does not depreciate over time.
Calculating depreciation expenses allows you to gain optimal control over your finances. Tax depreciation means assets will be classified into different classless as per their useful life. As a business owner, you can even write off assets quickly if you expect them to perish before the specified period.
An asset can be any property that possesses monetary value. It may be a tangible or an intangible asset. A tangible asset is one that you can see and touch, while the opposite is true for intangible ones.
An example of tangible assets would be machinery, while goodwill or copyright are examples of intangible assets. Both types of assets can be sold and depreciated accordingly. The sole difference lies in the name of the process, as depreciating intangible assets is termed amortization.
While multiple depreciation methods are to be used, you can only opt for one on the tax return. As a small business owner, you can also use different methods for bookkeeping and taxes. However, choosing the same method for both purposes is also a viable idea.
Now, take a look at the options you can use for your business:
- Double-declining balance
- Units of production
The straight-line method (SLM) is the simplest and most used depreciation method. It merely requires you to charge a constant rate of depreciation throughout the asset’s lifetime. Its formula is:
Annual Depreciation = (Asset cost – Salvage value) / Asset’s useful life
For instance, your business bought machinery for $200,000 with an expected life of 20 years and a salvage value of $50,000.
In this case, your business will deduct ($200,000 - $50,000) / 20 = $7,500 every year from the asset’s value.
This method is ideal for small firms with simple accounting needs and measures.
The double-declining balance method (DDB) method is also commonly used to account for a fixed asset’s depreciation. It counts as an acceleration method, and as the name suggests, it deducts twice the value of the assets. The double-declining deprecation formula is:
Annual Depreciation = 2 x Straight-line depreciation percent x Asset value at the start of the accounting period.
Asset value = Asset cost - Total depreciation (the accumulated depreciation until the calculations)
Let’s continue the example stated in the section on the SLM. This way, the machinery is depreciated for 20 years, meaning its SLM rate amounts to 10%.
For one year under the DDB method, the depreciation will be:
2 x 0.10 x $200,000 = $40,000
So, your business will reduce $40,000 every year, and the asset value will be $160,000. The calculations for the next year will look like this:
2 x 0.10 x $160,000 = $32,000
Although the process remains the same, you will be deducting less depreciation every year. The method is ideal for any business trying to recover its asset’s value quickly.
Unlike the SLM, the unit of production method is a two-step procedure. Under this, your business needs to assign equal expanse rates to every unit produced. Doing so simplifies the production assembly process, allowing SMEs to focus on other activities.
The final calculation is conducted based on the asset’s output capacity and not the useful life. To commence the calculations, you can follow these steps:
Start by calculating the depreciation for every unit.
Per Unit Depreciation = (Asset cost – Salvage value) / Useful lifetime in production units
Now, calculate the accumulated depreciation of the produced units.
Accumulated Depreciation = Produced Units x Per Unit Depreciation
Let us continue the first example with a minor addition. Suppose the machinery purchased produces 2,000 units with a useful life of 500,000 units. Its depreciation calculation will look like this:
First Step - Per Unit Depreciation = ($200,000 – 2,000) / 500,000 = $0.396
Second Step - Accumulated Depreciation = $0.396 x 2,000 units = $792
For every unit produced, the machinery will incur a depreciation expense of $792. If you own a business with season-based operations, this method is ideal for you. Using this method for a high-value asset with inconsistent operations can incur suitable numbers for your business.
This method checks out for businesses that use an asset less as the years pass. As the name suggests, this method requires you to add the number of years the asset can function. The depreciation formula for this method is simple:
Depreciation = (Remaining life / Sum-of-the-years'-digits) x (Asset’s cost - Residual value)
Continuing the example above, the expected life of the machinery is 20 years, meaning its sum-of-the-years' digits is (1+2+3+4+5+6+7+8+9+10+11+12+13+14+15+16+17+18+19+20) = 210
After applying the formula, you get:
(20/210) x ($200,000 - $50,000) = $14,286 approx.
As a result, your business will write off $14,286 in the first year. This method quickly recovers the asset's value while keeping an even distribution.
To ensure your business is following the correct depreciation standards, you can use a depreciation schedule. This is nothing more than a table showcasing how the asset will depreciate in the coming years. The following information makes up for a depreciation schedule:
- Asset's description
- Purchase value
- Purchase date
- Depreciation method used
- Asset’s expected useful life
- Residual value
The matter can become complicated if your business owns a rental property, but here's a solution. A business can only depreciate the rented building and not the land it stands on. If you do not know the exact values, you can calculate the amount after viewing the taxable values.
For example: Assume the rented property renders an assessed tax value of $10,000. The building is worth $7,500, while the land holds $2,500 in value. In this case, you only own 75% of the property.
If the amount paid for the property is $15,000, 75% of $15,000 amounts to $11,250, which is the property’s depreciable value.
What if you paid extra fees during the purchase? You can deduct some expenses while you can't do so for others. For example, you can deduct expenses like:
- Association dues
- Prepaid interest on the mortgage
- Prorate real estate tax
- Insurance premium
However, you cannot deduct these expenses:
- Agreed on back taxes
- Title insurance
- Legal fee
- Transfer tax
And what if you significantly improved the property before renting it out? You can add some of these expenses to the depreciated value. Generally, these expenses add value and last more than a year, like the windows and flooring.
On the contrary, funds spent on maintaining the property are deductive only after renting the property or if it’s currently advertised for rent.
As a small business owner, you can claim depreciation expenses on your tax returns. Are you wondering how? By simply filing the IRS Form 4562. Keep the given information handy before filing depreciation:
- Asset's value at the time of filing
- Asset's receipt
- Asset usage start date
- Total income in question
Funds play a crucial role, and even more so for small businesses. To maintain the proper functioning of a small business, you must be adept with critical concepts like depreciation. The article has provided every detail you may need as a business owner.
You can leverage the information given and enhance your business' financial health starting today. If you're looking to outsource your bookkeeping needs so that you can focus on scaling your business, get in touch with Fincent's expert bookkeeping services today!