Depreciation is defined as a portion of the cost that reflects
the use of a fixed asset during an accounting period. A fixed
asset is an item that has a useful life of over one year.
An accounting period is usually a month, quarter, six months
or one year. Let's say you bought a desk for your office on
January 1, for $1000 and it was determined that the desk had
a useful life of seven years. Using a one year accounting
period and the "straight-line" method of depreciation,
the portion of the cost to be depreciated would be one-seventh
of $1000, or $142.86.
Most non-accountants roll their eyes and shudder when the
topic of "depreciation" comes up. This is where
the line in the sand is drawn. Depreciation is far too complicated
to try and figure out, or so it seems to many. But is it really?
Surely the definition of depreciation mentioned above is not
that difficult to comprehend. If you look closely you will
see that there are five pieces of information you must have
in order to determine the amount of depreciation you can deduct
in one year. They are:
The nature of the item purchased (the desk).
The date the item was placed in service (Jan 1).
The cost of the item ($1000).
The useful life of the item (seven years).
The method of depreciation to be used (straight-line)
The first three are easy to figure out, the second two are
also easy but require a little research. How do you figure
out the useful life of an item? Let me regress for a moment.
There is "book depreciation" which is based on the
real useful life of an item, and there is the IRS version
of what constitutes the useful life of an item. A business
that is concerned with accurately allocating its costs so
that it can get a true picture of net profit will use book
depreciation on its financial statements.
However, for tax purposes the business is required to use
the IRS method. The IRS may have shorter or longer useful
lives for fixed assets causing a higher or lower depreciation
write-off. The higher the write-off, the less tax a business
pays. The long and short of it is that you end up having to
create a book financial statement and a tax financial statement.
So, most small businesses that aren't concerned with a precise
measurement of their net profit use the IRS method on their
books. This means that all you have to do is look in IRS Publication
946 to find the useful life of a particular item.
The last piece of information you need is found by determining
the method of depreciation to use. Most often it will be one
of two methods: the "straight-line" method or an
accelerated method called the "double-declining balance"
method. Let's briefly discuss these two methods:
Straight-line
This is the simple method mentioned in the definition above.
Just take the cost of the item, divide it by the useful life
and you've got the answer. Yes, you will have to adjust the
depreciation for the first year you placed the item in service
and for the last year when you removed the item from service.
For instance, if your depreciation for one year was $150 and
you placed the item in service on April 1 then divide $150
by 12 (months) and multiply $12.50 by 9 (months) to get $112.50.
If you removed the item on February 28 then your deduction
will only be $25.00 (2 x $12.50).
Double-declining balance
The idea behind this method is that when an item is purchased
new, you will use up more of it in the earlier years of its
life, therefore, justifying a higher depreciation deduction
in the earlier years. With this method, simply divide the
cost of the item by the useful life years as in the straight-line
method. Then, multiply that result by 2 (double) in the first
year. The second year, take the cost of the item and subtract
the accumulated depreciation. Next, divide that result by
the useful life and multiply that result by 2, and so on for
each remaining year.
But, wait! You don't have to do this. The IRS provides tables
that have the percentages worked out for each year of the
two different methods. Not only that, they have set up special
first year "conventions" that assume you purchased
your depreciable fixed assets on June 30. This is called the one-half
year convention. The idea behind this is that you may have
bought some items earlier than June 30 and some after that
date. So, to make it easy to figure out, they assume the higher
and lower depreciation amounts will all average out.
Actually, the IRS doesn't even call it depreciation anymore.
They call it "cost recovery". Let's face it. This
is a political tool. Congress giveth and taketh away. They
have been playing with this system for years. If they want
to stimulate growth in business they will shorten the useful
life of assets so businesses can attain a higher write-off.
If they are not in the mood, they will extend the useful life
of an item. A good example is the 39 years set for the useful
life of commercial property. This means that if you lease
a building for your business and make improvements, those
improvements have to be depreciated over 39 years. Now congress
is working on a bill to drop that down to 15 years for leasehold
improvements.
Before December 31, 1986 we had ACRS or Accelerated Cost Recovery
System. Currently, we have MACRS or Modified Accelerated Cost
Recovery System. Every time congress tweaks the rules they
give it a different name.
Keep in mind there are different schedules for different properties.
For instance, residential real property is depreciated over
twenty-seven and one-half years and
non-residential real property is depreciated over thirty-nine
years. In addition, if more than forty percent of your total
fixed asset purchases occurred in the last quarter of the
year, then, you must use a mid-quarter convention. This convention
assumes that your purchases made in the last quarter of the
year were made on November 15. This prevents you from buying
a big expensive piece of equipment on December 31 and treating
it as though it were purchased on June 30 and gaining a larger
depreciation expense.
Understanding how basic depreciation works can be valuable
to the small business owner because it helps to know the tax
implications when planning for capital equipment purchases.
John W. Day, MBA is the author of two courses in accounting
basics: Real Life Accounting for Non-Accountants (20-hr online)
and The Heart of Accounting (4-hr PDF). Visit his website
at http://www.reallifeaccounting.com
to download for Free his 3 e-books pertaining to small business
accounting and his monthly newsletter on accounting issues
