Depreciation is the systematic allocation of the depreciable amount of an asset over its useful life. Having a professional bookkeeper do it for you can significantly optimize asset utilization and tax efficiency.
Don’t let the word ‘depreciation’ throw you off just because it sounds technical. Depreciation is a way of showing how business assets, such as tech equipment or machinery, lose value over time.
It’s a key tool for reducing your business’s tax burden, so it’s an important strategy for small business owners to understand.
To put it simply, it’s like saying something isn’t worth as much as when it was new. Businesses use depreciation to spread out the cost of significant purchases over the time they use them instead of absorbing it all at once.
So, instead of immediately deducting the entire cost in a single tax year, depreciation allows you to gradually write off portions of the expense over the asset’s useful life. This approach grants you greater financial control by strategically planning the annual deductions.
Still doesn’t make sense?
Let’s make it simpler with an example:
Suppose you buy a delivery van for $30,000 for your small business in 2024. Without depreciation, you’d have to report the full $30,000 as an expense in the year you bought it (2024), which could significantly reduce your profits for that year, subsequently impacting your taxes.
With depreciation, you can spread out the cost of the van over its useful life, let’s say, five years. Instead of deducting $30,000 all at once, you could deduct $6,000 ($30,000 divided by 5) each year for five years. This way, you have a more balanced expense over time, which can help in managing your taxes and cash flow more effectively.
Depreciation timelines
The duration over which you depreciate an asset corresponds to its anticipated useful life. For instance, a smartphone typically maintains its utility for about 15 to 18 months. Tax regulations classify assets into distinct categories, each associated with its own predetermined useful life.
However, businesses may opt for alternative depreciation methods in their financial reporting, tailoring the asset’s useful life to align with their operational expectations.
Think about it this way: A photography studio invests in high-end cameras and lighting equipment. While the IRS sets a standard depreciation period for such equipment, the entity should use GAAP guidelines while deciding the depreciation timelines.
So how does GAAP want an entity to depreciate its assets?
As per GAAP the useful life is the period over which an asset is expected to be available for use by an entity. In other words, it is the period over which the economic benefits embodied in the asset are expected to be consumed by the entity.
What are assets?
Assets, often interchangeably referred to as ‘property’ by the IRS, include items possessing monetary value, categorized as either tangible or intangible.
Tangible and intangible assets
Tangible assets are physical items (owned by a company) that can be touched, such as office buildings, delivery trucks, computers, and machinery.
Intangible assets lack physical presence but retain inherent value, eligible for purchase and sale. Examples include brand names, domain names, customer databases, proprietary algorithms, copyrights, and other forms of intellectual property.
Both tangible and intangible assets are subject to depreciation. In the case of intangible assets, the process is termed amortization, reflecting the gradual recognition of the asset’s diminished value over time.
The IRS lays out specific criteria regarding the types of assets eligible for depreciation. To qualify, an asset must satisfy the following conditions:
- Ownership by your business
- Utilization within your business operations or to generate income
- Ability to ascertain its useful lifespan
- Anticipation of a lifespan exceeding one year
Examples of assets commonly subject to depreciation in small business settings include but are not limited to the following:
- Vehicles
- Real estate holdings
- Machinery and equipment
- Office furnishings
- Software and technology
- Computer systems
- Infrastructure and utilities
- Leasehold improvements
What constitutes a depreciation schedule?
A depreciation schedule is like a detailed plan showing how much the value of each of your business assets decreases over time.
Typically, such a schedule includes the following key details:
- Asset description — providing clarity on the nature of the item.
- Date of acquisition — crucial for tracking the asset’s lifecycle.
- Total acquisition cost — ensuring an accurate assessment of depreciation.
- Estimated useful lifespan — guiding the depreciation process.
- Depreciation method employed — defining the approach taken for asset devaluation.
- Salvage value — indicating the residual worth of the asset upon reaching the end of its useful life (for instance, the potential resale value at a scrapyard).
- Current year’s deductible depreciation amount — facilitating tax planning and compliance.
- Cumulative depreciation figure — reflecting the total depreciation recorded over time.
- Net book value of the asset, calculated by deducting the cumulative depreciation from the total acquisition cost — providing insight into the asset’s current value.
Different types of depreciation
Businesses have various methods at their disposal for calculating depreciation to manage assets for financial reporting or tax purposes.
It’s worth noting that the depreciation expense recorded in financial statements might differ from the deduction claimed on tax returns.
Consequently, some small businesses opt for distinct methods for their financial records and tax obligations, while others prefer simplicity by aligning their book depreciation with tax regulations.
So the question that arises is, how should an asset be depreciated?
Which depreciation method should be used by an entity?
As per GAAP, an entity should select a method of depreciation based on the pattern in which the economic benefits embodied in the asset are consumed by the entity.
In short, if an asset provides equal benefit to the entity over its useful life, then equal depreciation should be charged each month.
Conversely, if an asset provides benefits based on its usage capacity like the number of units produced for a plant, then it should be depreciated based on the number of units produced each month.
Let’s explore the available options for both financial records and tax purposes.
Straight-line depreciation
Description | Usefulness | Calculation |
The most prevalent and straightforward approach.
It evenly distributes the asset’s cost over its useful lifespan. |
Particularly well-suited for small businesses with uncomplicated accounting systems.
Limited professional assistance for tax matters is required. |
Asset cost – salvage value) / useful life
By dividing the asset’s cost (minus salvage value) by its useful life, businesses ascertain the annual depreciation expense to be recognized. |
Example
Your software company invests $100,000 in upgrading its server infrastructure.
The salvage value is projected to be $10,000, and the servers are anticipated to have a useful life of 5 years.
Plug these values into the formula explained above.
(100,000 – 10,000) / 5 = $18,000
Annually, the company will depreciate $18,000 from the server infrastructure’s value over the 5-year period.
Double-declining balance depreciation
Description | Usefulness | Calculation |
Presents a more intricate strategy for depreciating assets.
Allows for a front-loaded depreciation pattern. A greater portion of the asset’s value is expensed in the initial period post-acquisition. A gradual reduction occurs in subsequent periods. |
Beneficial for assets providing maximum benefits during the initial years of their use and there is a significant decline in their benefits as they age.
Requires expert assistance due to the rapid depreciation experienced during the early stages of asset ownership. |
Formula: (2 x straight-line depreciation rate) x book value at the beginning of the year
Multiplying the straight-line depreciation rate by 2, then applying this doubled rate to the asset’s book value at the beginning of each year. The book value is calculated as the asset’s cost minus the cumulative depreciation recorded. This method disregards salvage value in its calculation. |
Example
Assuming the technology upgrade has a total cost of $100,000 and a useful life of 5 years, we’ll first determine the straight-line depreciation rate:
Straight-line depreciation rate = 1 / useful life = 1 / 5 = 0.20 or 20%
Now, applying the double-declining balance method:
Year | Depreciation expense | Book value |
1 | (2 x 0.20) x $100,000 = $40,000 |
$60,000 ($100,000 – $40,000) |
2 | (2 x 0.20) x $60,000 = $24,000 |
$36,000 ($60,000 – $24,000) |
3 | (2 x 0.20) x $36,000 = $14,400 |
$21,600 ($36,000 – $14,400) |
4 | (2 x 0.20) x $21,600 = $8,640 |
$12,960 ($21,600 – $8,640) |
5 | (2 x 0.20) x $12,960 = $5,184 |
$7,776 ($12,960 – $5,184) |
By the end of the fifth year, the technology upgrade has a book value of $7,776. It is worth noting that the book value of an asset will never be zero when using the double-declining method of depreciation.
Sum-of-the-year’s-digits depreciation
Description | Usefulness | Calculation |
Offers an alternative approach to asset depreciation
Enables a higher allocation of the asset’s cost in the initial years of its useful life, followed by a gradual reduction in subsequent years. |
Beneficial for assets whose benefits decrease after each passing year.
It offers a more balanced distribution compared to the accelerated double-declining balance method. |
Multiplying the remaining lifespan of the asset by a fraction derived from the sum of the digits in its useful life, then subtracting the salvage value from the result. |
For SYD depreciation, sum up the digits corresponding to each year of the asset’s useful life, generating a fraction applicable to each depreciation year.
For instance, an asset with a five-year useful life would have a SYD value of 15:
5 + 4 + 3 + 2 + 1 = 15.
Next, divide the remaining lifespan of the asset by the SYD value, then multiply the quotient by the asset’s cost to determine the depreciation write-off for the year. While this process may seem intricate in theory, its application is relatively straightforward, as illustrated in the example below.
Example
Given:
Asset cost: $100,000
Salvage value: Not considered in SYD method
Useful life: 5 years
SYD value: 5 + 4 + 3 + 2 + 1 = 15
Year | Factor for each year (A) | Depreciation Factor (B) = (A) / 15 | Depreciation expense = (B) * Depreciable Amount | Book value = Cost – Accumulated depreciation |
1 | 5 | 0.3333 | $30,000 | $70,000 |
2 | 4 | 0.2667 | $24,000 | $46,000 |
3 | 3 | 0.2 | $18,000 | $28,000 |
4 | 2 | 0.1333 | $12,000 | $16,000 |
5 | 1 | 0.0667 | $6,000 | $10,000 |
By the end of the fifth year, the technology upgrade is fully depreciated, and its book value is the same as the salvage value.
Units of production depreciation
Description | Usefulness | Calculation |
Assesses equipment depreciation based on its operational output.
This could refer to the tangible output, such as widgets produced or the hours of service rendered. |
Suitable for small businesses seeking to depreciate high-value equipment or machinery based on quantifiable, widely accepted outputs throughout its lifespan, typically provided by the manufacturer’s specifications.
Beneficial for those looking to adjust depreciation amounts according to usage fluctuations over time |
(Asset cost – Salvage value) / Units produced in useful life
By adding up all the units made in a year, you determine how much depreciation to record. When all units are depreciated, the asset is seen as no longer useful, and no more depreciation can be claimed. |
Example
Considering hours as units, let’s apply the same technology upgrade example.
Recalling the details of the technology upgrade, it was acquired for a total cost of $100,000, a salvage value of $10,000, so the depreciable amount is $90,000.
Hourly depreciation rate = Total cost / Total expected usage hours
= $90,000 / 90,000 hours
= $1 per hour
Using this depreciation rate, we can determine the depreciation expense for each year based on the actual hours of usage:
Year | Usage hours | Depreciation expense |
1 | 20,000 | 20,000 hours × $1/hour = $20,000 |
2 | 25,000 | 25,000 hours × $1/hour = $25,000 |
3 | 15,000 | 15,000 hours × $1/hour = $15,000 |
4 | 20,000 | 20,000 hours × $1/hour = $20,000 |
5 | 10,000 | 10,000 hours × $1/hour = $10,000 |
The total depreciation expense over the five years amounts to $20,000 + $25,000 + $15,000 + $20,000 + $10,000 = $90,000 which equals the depreciable amount of the technology upgrade.
For our example, the depreciation expense will vary annually based on the actual hours of usage. Keep in mind that the total depreciation over the asset’s life should not exceed $90,000 or 90,000 hours.
How to leverage depreciation to increase small business tax savings?
To maximize small business tax savings through depreciation, it’s essential to understand how it works. Depreciation allows you to deduct the cost of certain assets over time, reducing taxable income and ultimately lowering your tax bill.
By strategically timing asset purchases and choosing depreciation methods that align with your business needs, you can optimize tax savings. Additionally, take advantage of bonus depreciation and Section 179 deductions when applicable to accelerate deductions and increase savings. Don’t forget to regularly review and update depreciation schedules to ensure accuracy and compliance with tax regulations.
The bottom line
Making the most of depreciation by getting the hang of its basics can be your ticket to successful financial management, particularly if you’re an asset-heavy business striving for sustainable growth.
However, choosing the most suitable type of depreciation for your business, wading through the calculations, and filing IRS Form 4562 in order to claim depreciation expense on your tax return require financial expertise and take up additional time and space on your plate.
When you trust CoCountant with your books, we assign you a dedicated virtual bookkeeper experienced in ensuring your books adhere to GAAP standards, optimizing asset utilization and tax efficiency.
This way, small business owners like yourself can rest assured that follow-ups on invoices, reconciling bank statements, and calculating depreciation are all taken care of — and that too without the hassle of hourly rates!