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A Guide to Depreciation for Small Business Owners

By Ershad Ullah September 23, 2022 | Tags: ,

For every asset your small business depreciates, you need a depreciation schedule. As a business owner, your accountant will tell you to keep a record of every purchase, but one of the most important records you must keep is a depreciation schedule when making a large asset purchase. 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.

A Guide to Depreciation for Small Business Owners

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 fixed asset register. As such, as they depreciate, the value of your business’s assets decreases. 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 another 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 income tax expense.

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 more in taxes.

What kind of assets do you depreciate?

Fixed assets that won’t be consumed within one year are subject to depreciation. Your building, factory equipment, computer, and furniture are considered fixed assets and may be depreciated. Intangible assets, such as email lists or patents you bought from a third party, are subject to amortization, which is the word used for the depreciation of intangible assets. You don’t depreciate all assets. Office supplies, inventory, and low-cost items don’t get the same treatment because they usually get used up in a year or less.

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 need to use the asset 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 (however current accelerated depreciation rules for small businesses allow for the assets to be depreciated in the year of acquisition)

How to create a Depreciation Schedule

Depreciation schedules serve as a roadmap to an asset’s depreciation expenses. Businesses create depreciation schedules to outline how a fixed asset’s costs are expensed over its useful life.

You can’t immediately write off the purchase of many fixed assets. Instead, you expense the cost over its useful life, which is the expected amount of time the asset will generate revenue and be of use to your business. 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. The land is one of the few fixed assets that might be exempt from depreciation, but nearly everything else will be affected.

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
  • the salvage value of the asset.

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

There are several types of depreciation, and the methods are set out below.

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 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 the 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 upfront.

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.

Always talk to your accountant, about which depreciation method is best suited to your business.

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