Small businesses can write off expenses for tax deductions, however, larger purchases can’t simply be written off in one go. That’s where depreciation comes in.
What is depreciation, and how can you apply it to your business’s accounting? We’ll cover all the basics (and then some) in this guide.
What is depreciation in accounting?
In accounting, depreciation is the decrease of an asset’s value over time. As business assets age, they will depreciate until they eventually reach a value of zero dollars.
You might be familiar with this process already in other areas of your life. For example, vehicles tend to lose a large chunk of their value as soon as you drive them out of the dealership — that’s depreciation.
In a business context, depreciation affects fixed assets like computers, machinery, office equipment, and buildings. Land is one of the few fixed assets that might be exempt from depreciation, but nearly everything else will be affected.
What is the purpose of depreciation?
Depreciation itself is a fact of life — material goods lose value over time. Tracking this in your accounting practice might seem unnecessary at first but there are several benefits of accounting for depreciation.
Depreciation helps provide an accurate picture of asset value
Depreciation is considered a cost of doing business — as such, it should be accounted for on your Profit and Loss (P&L) report as an expense. This helps provide a more accurate picture of the value of your business and its assets, as well as the costs incurred over the course of the year.
Depreciation helps provide an accurate picture of business value
Your business’s assets are part of its valuation, and they should be listed on your depreciation balance sheet (called the fixed asset register). As such, as they depreciate, the value of your business’s assets (and the business as a whole) decreases. It’s important to properly track this change in assets and valuation.
Depreciation can help lower your tax liability
Because business depreciation is considered an expense, and thus lowers your business’s profits, it also has important tax implications — namely, it can lower your tax liability. If you don’t properly account for depreciation, you can end up paying too much in taxes.
How does depreciation work?
Nearly all material goods lose value over time. With some assets, like machinery, wear-and-tear reduces effectiveness and increases maintenance costs. In other cases, newer versions of a piece of equipment or other asset will make yours worth less.
Businesses can account for this decreased value on their balance sheets, enabling a more realistic view of the business’s assets, as well as reducing tax liability.
How do you calculate depreciation?
Depreciation is a complex area, but the basic calculations are made up of a few consistent variables:
useful life: the length of time the asset is considered productive. Once it’s exceeded its useful life, it becomes more cost-effective to simply replace the asset
salvage value: salvage value (also known as residual value) is what the asset is worth after it’s exceeded its useful life. Most assets generally have some salvage value, even if it's only for parts
cost of asset: the total overall cost of the asset, including purchase price, taxes, setup and maintenance costs, shipping, and any other associated expenses.
What is a depreciation schedule?
A depreciation schedule is simply a table that shows how much each asset will depreciate over a given time. It usually includes some or all of the following details:
a description of the asset
the date the asset was purchased
the total price paid for the asset
the expected useful life of the asset
which depreciation method is used (more on this below)
the salvage value of the asset.
Types of depreciation
As mentioned above, there are several types of depreciation. Each one has a unique scenario when it’s most useful.
Straight-line depreciation
The simplest form of depreciation is straight-line depreciation. This can be used to calculate the value of a fixed asset and spread it evenly over its useful life.
Who should use it: Primarily small businesses with simple accounting systems.
How it works: Divide the cost of the asset, minus its residual value, over its useful life. The result is how much depreciation you deduct each year.
How to calculate it: (Asset Cost - Salvage Value) / Useful Life
Example: You buy a new lawnmower for your landscaping business at a cost of $3000. The salvage value is $400, and the useful life is 10 years. Using the equation, you get: (3000 - 400)/10 = 260. So $260 is the straight-line depreciation value per year.
Units of production depreciation
This form of depreciation of assets provides a simple way to calculate depreciation based on how much work an asset does. The unit of production can either be hours of service or a specific output, like cups of coffee created by a coffee maker.
Who should use it: This type of asset depreciation is best used by small businesses writing off gear that has a quantifiable and widely accepted output. Since it requires more detailed tracking of the asset, it’s usually reserved for high-value equipment.
How it works: You determine the dollar value of depreciation for each unit produced or hour used. Then you add up the units or hours for the year to determine how much you can write off.
How to calculate it: (Asset Cost - Salvage Value) / Units Produced in Useful Life
Example: Let’s stick with the lawnmower example. Remember, it cost $3000 and had a salvage value of $400. Let’s say it’s rated for 1000 uses on average-sized lawns by the manufacturer. So, we get: (3000 - 400)/1000 = 2.6. The lawnmower loses $2.60 every time you cut a lawn with it.
Diminishing value depreciation
Also known as “sum-of-the-year’s-digits (SYD) depreciation,” this method of depreciation of business assets focuses more on the asset’s cost in the earlier years of the useful life, with the depreciation amount dropping in later years.
Who should use it: Any business that wants to recover more value up front.
How it works: First, add up the digits in the asset’s useful life. This gives the SYD number. You then divide the asset’s remaining useful life by the SYD, and then multiply that number by the cost to get that year’s depreciation.
How to calculate it: (Remaining Useful Life / SYD) x (Asset Cost - Salvage Value)
Example: Our riding lawn mower costs $3000, has a salvage value of $400, and a useful life of 10 years. The 10-year useful life gives an SYD of 55 (1+2+3+4+5+6+7+8+9+10=55). Finally, let’s say we’ve been using it for 3 years, so the remaining useful life is 7 years. The equation is: (7/55) x (3000 - 400) = 331.91 (rounded up). So for the third year’s taxes, you’d write off $331.91.
Double-declining depreciation
This is another depreciation method that writes off more of the value early in the asset’s life, with diminishing amounts over time until it reaches zero. Double-declining depreciation is based on the straight-line rate of the asset and does not take the salvage value into account.
Who should use it: Businesses that want to recover more of the asset’s value at the beginning of its life.
How it works: For this method, you use double the straight-line depreciation rate and apply it to the remaining book value of the asset at the beginning of the year. So, for the first year, it will be based on the initial cost of the asset. For the second year onward, it will be based on the depreciated value of the asset.
How to calculate it: (2 x Straight-line Depreciation Rate) x Book Value at the Start of the Year
Example: Let’s use the lawnmower example one more time. Remember, it costs $3000 and has a useful life of 10 years.
Since the useful life is 10 years, the straight-line depreciation rate is 10% (it loses 10% value each year for 10 years).
So our formula for the first year will be (2 x .10) x 3000 = 600. The lawnmower will depreciate $600 the first year, leaving the book value at $2400.
For the second year, the formula will be (2 x .10) x 2400 = 480. You’ll write off $480, and the remaining book value will be $1920.
What are common depreciation rules?
Depreciation is a complex system, and since it directly impacts tax liabilities, there are some rules in place to ensure everyone operates on the same page.
General depreciation rules
The most general depreciation rules govern the amounts that can be claimed based on the asset’s useful life. Under these rules, an immediate write-off can be applied to:
Items costing less than $100 that are used to earn business income
Items costing up to $300 that are used to earn income other than from a business, like employee-provided tools.
Simplified depreciation rules
Small businesses can use simplified depreciation rules that allow more flexible instant write-offs. These rules apply to businesses that have an aggregated turnover of:
Less than $10 million from 1 July 2016 to present
-and-
Less than $2 million for previous income years
Additional depreciation rules
Beyond the general and simplified depreciation rules, there are a few other sets of guidelines that apply to capital works and certain other business expenses:
Capital works are written off over a longer period than other depreciating assets
The costs of setting up or terminating a business, as well as project-related expenses, are governed by different rules.
You can only claim depreciation deductions to the extent that you use the asset to earn income. So if you use that lawnmower for business 75% of the time, but for personal use the other 25%, you can only claim 75% of the depreciation for the year.
What assets can be depreciated?
There are some specific criteria that govern what types of assets can be depreciated (in terms of tax deductions). The criteria include the following:
you must be the owner
you need to use it in your business, or to otherwise earn income
you need to be able to determine the useful life of the asset
the asset needs to be expected to last longer than one year.
Fixed assets
Most depreciating assets fall under the umbrella of “fixed assets.” Fixed assets are tangible assets that you expect your business to own and use for more than one year.
Generally, a fixed asset is a high-value item, and there’s often (but not always) a correlation between the price of the item and the expected useful life. When we discuss depreciation, we generally mean the depreciation of fixed assets.
Depreciation and accounting doesn’t need to be complicated
Depreciation can seem like a complex topic (and it often is). However, it’s possible to simplify your accounting and get more value out of the assets you already have — without the headache.
MYOB can help. Our small business accounting solutions help you crunch the numbers quickly so you can focus on what really matters: your business. Start a FREE trial today!