Depreciation is a vital calculation method used in accounting and finance. If you're unfamiliar with the concept, it sounds like a negative attribute of running a startup. In reality, it’s an accounting method used to lower income tax using business assets.
Chances are you have assets in depreciation already or assets that qualify. In this article, we’ll go over the tax benefits of this method, how it affects your business and how to calculate depreciation.
What Is Depreciation?
Depreciation is an accounting method used to spread out the value of a business asset over time rather than expensing the entire asset cost after purchase. Companies save money on tax payments by breaking apart the cost over the asset’s lifetime.
Depreciation is specific. Intangible assets are amortized, not depreciated. Assets must meet criteria set by the IRS to depreciate in one of five methods.
Assets must meet the following criteria:
- Owned by the founder or partners of the company
- Used in business (such as a building or computer) or used to produce income for the company (such as equipment)
- Determinable useful life
- Will last more than a year
- Physical and tangible
Assets that are not considered fixed and cannot be depreciated are:
- Land
- Collectibles
- Investments
- Personal property (not related to the business)
- Assets used for under one year
Depreciation is no longer applicable to the asset after the total amount is paid or is no longer in use.
Where Is Fixed Asset Depreciation Found?
You can find depreciation expenses on your balance sheet beneath the expenses column. Depending on the depreciation method applied, you’ll see the cost over your company’s monthly, quarterly, or yearly accounting period.
The number of years an asset goes through depreciation depends on how long the asset will be helpful. You will most likely have multiple assets in depreciation with varying timelines. Ensure your bookkeeper or CPA keeps diligent records of asset purchases and regularly monitors your expenses.
Definitions To Know
There are key terms used in depreciation formulas all founders should know. Having this information ahead of time makes solving multi-step equations easier.
- Salvage value: The book value of an asset once depreciation is completed.
- Book Value: An asset’s book value at the beginning of an accounting period. Book value is found by deducting accumulated depreciation.
- Accumulated depreciation: Cumulative depreciation of an asset through specific periods of the asset’s life.
Example of Accumulated depreciation:
If a printer is bought at $2,000 with a lifespan of four years, the accumulated depreciation is $500 making the book value after one year $1,500.
Three Methods Of Depreciation
There are five types of depreciation, but only three benefit small businesses and startups. The most commonly used methods are the straight-line depreciation method, the declining balance method, and the sum-of-the-years-digits process.
Each method has its own advantages and disadvantages, so choosing the right one for your business is essential. Ultimately, it comes down to your company’s assets and uses to generate income for your business.
Machines and computers have vastly different life cycles and do not experience the same wear and tear. This is where the difference in methods helps companies adjust asset expenses properly.
1. Straight-Line Depreciation
The straight-line method is the simplest of all five and the most common in the top three. The asset is depreciated equally until the cost has been paid off fully over the allotted time. Every tax year, the depreciation of the asset remains the same.
The formula for straight-line depreciation is:
Cost - salvage value ÷ asset life
Example:
Company X purchases a 3D printer for $210,000 with an estimated life of 10 years and a salvage value of $10,000.
$210,000 - $10,000 = $200,000
$200,000 ÷ 10y = $20,000 depreciation per tax year
Company X expenses of $20,000 each month are reported as cash out and supplemented with $20,000 made by income made using the 3D printer.
2. Declining Depreciation
Declining depreciation is an accelerated method that records higher depreciation costs during the first few years of the asset’s life. As time passes the expense reduces until the asset is paid off.
Companies with assets that have a short lifespan, that eventually become obsolete (like old technology) or quickly lose value benefit from this method. Startups and small businesses looking to save money after a large purchase also benefit from this method.
Examples of quick-decaying assets include:
- Computers and electronic devices (think of how quickly newer models replace iPhones)
- Company vehicles
- Tools (consistently or used daily)
The formula for calculating declining depreciation is:
Current book value x depreciation rate (%)
Example:
Company x purchases a machine for $1,000 with a life expectancy of 5 years, no salvage value, with a depreciation rate of 15%
$1,000 x 15% = $150
In year one, depreciation is $150 leaving a book value of $950. In year two, depreciation is $142 (15% of $950). The pattern continues until the asset is paid off.
3. Sum Of The Years (SYD)
SYD is another accelerated depreciation method that adds the year’s numbers to the asset’s depreciation. Like declining depreciation, a company’s expenses will be high at the beginning of an asset’s life and slowly decrease. Using SYD is the most beneficial method when an asset loses a lot of value in the first stages of its life.
The formula to find depreciation for SYD is:
Each year’s digit ÷ the sum of the asset’s life digits added together
Example:
Company X purchases a machine with a three-year lifespan. Each year’s digits are 3, 2, and 1. The sum of the year’s digits equals 6. Then, the year’s numbers are divided by the sum.
Year one: 3/6 = 50%
Year two: 2/6 = 33%
Year three: 1/6 = 17%
1, 2, 3 (each year’s digit) ÷ 6 (sum of the year’s numbers added together)
All percentages added together should equal 100%.
Selling Assets
When depreciation is completed, you can sell the asset at market value. That can mean selling a machine to the scrap yard, selling a work van to a used car dealership, or selling a computer to a second-hand store. If a profit is made on the asset, you count that as business income. Losses, on the other hand, can be deducted.
Depreciation And Taxes
Depreciation lowers taxes. To provide accurate records to the IRS, you need to track cash in and out. Each month, your income statement should have depreciation beneath the expense column. Any assets sold should be an income or loss. All of these numbers are recorded by your accountant or bookkeeper and should be kept neatly organized for tax purposes.
You don’t want your bookkeeper scrambling at the end of the fiscal year. Tax season can become a nightmare when your books aren’t correctly taken care of. Running into tax issues can take months to work through, and money owed can be held until everything is sorted out, especially if the IRS is on the path to auditing your business.
Our Zeni dashboard is organized to make report finding easier and simple. We keep everything on one page with side-by-side tiles showing net income, cash in and out, statements, and more. You can easily pull expense reports to ensure depreciation is calculated correctly months before tax season.
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