If there is a “black hole” in bookkeeping and accounting – a place that no light can ever escape from and where nothing is as real as it seems, it has to be the world of depreciation.
It’s almost like the old maps from the Age of Discovery – “Here there be dragons” – where the mapmakers simply didn’t know what was going on and took a guess at what might be there. Depreciation, like an unknown ocean, has swallowed its fair share of things, but once you take a good look at it with a bookkeeping professional, it isn’t as bad as it seems. The downside is that many times, owners aren’t sure what to ask or even if an item can be depreciated, so the question is never asked. If those same owners are using a prepackaged software, they turn a blind eye to the very real opportunities that depreciation schedules can offer them when it comes to cost savings.
That is a dragon that can bite you!
Let’s take a look at the most common three types.
- Straight line depreciation – This is the “usual” method of reducing the carrying value of a fixed asset over its useful life. Not only is it easy to calculate, unless stipulated otherwise, it offers an honest reflection of how a fixed asset may be consumed. Since we are depreciating in a “straight line” the overall value of the asset, once determined, and the salvage value of the asset, once used, is a simple “connect the dots” technique over the useful life.
An example of this might be where a company purchases a Widget for $60,000 with an estimated useful life of 5 years. The known salvage value is $10,000, so the depreciable asset cost is $50,000. $50,000 over five years equals $10,000/year, this the asset depreciates 20% each year and offers the company a “write down” of the asset of $10,000 per year.
- Accelerated Depreciation – Accelerated depreciation is the allocation of an asset’s cost in a faster manner than the straight line depreciation. This method is used, especially with equipment, to reflect the additional maintenance costs that may be associated with an older unit that will no longer be warrantied by the manufacturer or may require considerable time and money to keep in running condition. Compared to straight line depreciation, accelerated depreciation will mean 1) more depreciation in the earlier years of an asset’s life and 2) less depreciation in the later years of the asset’s life. [Note that the total amount of depreciation over the asset’s life will be the same regardless of the depreciation method used.] Hence, the difference between accelerated depreciation and straight line depreciation is the timing of the depreciation.
There are several ways to calculate accelerated depreciation, such as double-declining balance (200% or 150%) and sum-of-the-years’ digits (SYD). The best news for companies with assets that use accelerated depreciation schedules is that, for ease of calculations, the IRS allows companies to use straight-line depreciation in financial statements while using accelerated depreciation for tax purposes. As you can guess, this allows enterprises to defer taxes but does increase the complications of calculating depreciation.
- Section 179 Depreciation/Deduction – Section 179 is less of a depreciation schedule than a tax deduction. It was specifically designed for small businesses who are purchasing assets and do not need to or cannot, capitalize and depreciate an asset. Essentially, it is a method of expensing and incentivizing small business owners to grow their businesses by providing an immediate expense deduction.
The Section 179 expense deduction is limited to such items as cars, office equipment, business machinery and computers. This speedy deduction can provide substantial tax relief for business owners who are purchasing startup equipment – even costing hundreds of thousands of dollars. In general, Section 179 allows up to $500,000 for small business purchases and schedules that out over a specific, but a much shorter period of time.
Confused? You should be – because “here there be dragons.” On the other hand, when you partner with a professional (linked to BookkeepWithUs), you can understand how these apply and the smartest way to use them in your specific business model. It’s not easy, but it is one of the most useful tools you can have for your business!
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