How does Depreciation Work?

Depreciation is one of those ‘off the wall’ accounting concepts. It is useful to your business, but many business owners don’t know what it means or how to account for it. Let’s take a good look at what depreciation is and when to use it.

So, you just purchased that snazzy new computer you have been eying for your business. How do you account for THAT? Well, you get to depreciate it!

Simple Explanation of Depreciation in AccountingWhat is depreciation? defines depreciation as “A noncash expense that reduces the value of an asset as a result of wear and tear, age or absolescense. Most assets lose their value over time (in other word, they depreciate), and must be replaced once the end of their useful life is reached.” (Read more at Investorwords.)

At the time of purchase, your new computer is considered an asset, not an expense. As you ‘use up’ the life of your computer, the costs are moved to expense. As an asset declines in value over time, you will reduce the value of the asset as you write off the cost as an expense.

What is a depreciable asset?

According to IRS Publication 946 the following conditions must be met to be able to depreciate property:
- It must be property you own.
- It must be used in your business.
- It must have a determinable useful life.
- It must be expected to last more than one year.

If these conditions are met, you can depreciate the property. Let’s take a look at a couple different business items you may purchase:

1)      Super fancy, engraved, expensive….PENCIL. Is this item owned by the business, Yes. Is it used in business, Yes. Does it have a determinable useful life, Yes. Expected to last more than one year….NO.

A pencil (I know, silly example, but easy to understand) has a very short useful life. That means that the cost of the pencil must go straight to expense, no depreciation allowed.

2)      Let’s go back to our computer example. Is this item owned by the business, Yes. Is it used in business, Yes. Does it have a determinable useful life, Yes. Expected to last more than one year, YES.

Computers are expected to last for 6 years, BINGO. This means the computer is an asset and depreciation can be allocated over time.

How do you account for depreciation?

Depreciation is a NON cash transaction. I think this is what makes it difficult to understand. Most business transactions have a cash flow that can be followed. Depreciation does not. It is more arbitrary than we are used to accounting being. There are three points that must be decided in order to determine your depreciation amounts.

1)      You need to determine your cost basis in the asset.  Typically this is the property’s cost (including sales tax, freight, installation and testing fees). There are exceptions to this rule. Be sure to do your research and/or contact your accountant.

2)      Next you will need to determine the life of the asset. The IRS Publication 946 has a wonderfully useful table called the ‘Table of Class Lives and Recovery Periods.”  This lists items used in business and their expected useful lives.

3)      Then the method of depreciation must be decided. The two main methods of depreciation are MACRS and Straight line. To determine which you should us, you can read more in the IRS Publication 946 and/or talk to your accountant.

Once you have determined cost, life and method, you are ready to calculate some depreciation!

While depreciation can be a tricky topic, it really doesn’t have to be. With a little research (or even the help of your accountant) you can track your depreciation like a pro.

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