Depreciation

What is depreciation? Depreciation is the process of deducting the total cost of something expensive you bought for your business. But instead of doing it all in one tax year, you write off parts of it over time. When you depreciate assets, you can plan how much money is written off each year, giving you more control over your finances. How To Account For It? We debit depreciation every year from the asset account up to the estimated life of the asset. it is a non-cash transaction, so it does not directly affect the net income of the company. We pass a journal entry every year debiting the depreciated amount from the machinery account. However, we calculate the amount of depreciation at the time of purchase of the asset. We calculate it through the following method: Depreciation = total cost of asset/ estimated life of the asset Journal entry we pass for depreciation goes like this: Depreciation a/c Dr. To Machinery a/c Depreciation is charged up to the years of estimated life until the original value completely gets eliminated. What kind of assets can you depreciate? The IRS sets guidelines for what types of assets you can depreciate. It needs to meet the following criteria: • You own it • You use it in your business, or to produce income • You can determine its useful life • You expect it to last more than one year Some common examples of assets depreciated by small businesses include: • Vehicles • Real estate • Equipment • Office furniture • Computers What is a depreciation schedule? A depreciation schedule is a table that shows you how much each of your assets will be depreciated over the years. It typically includes the following information: • A description of the asset • Date of purchase • The total price you paid for the asset • Expected useful life • Depreciation method used • Salvage value–how much you can sell it for once it’s past its useful life (e.g., how much a scrapyard would pay for your old work truck) How do I calculate depreciation? You can calculate depreciation in several ways. Generally, you take the original cost of the asset and subtract the salvage value. Then divide that number by the years you expect the asset to be useful. The IRS determines useful life based on a schedule set up for various assets. You can include a specific amount on your business tax return as an expense during each year of the asset’s useful life. There are different methods you can use to calculate depreciation: • Straight-line basis • Declining balance • Double declining • Units of production • Sum-of-the-years’ digits Each method calculates depreciation expenses differently. 1. Straight-line depreciation Straight-line is one of the simplest methods of depreciation. In this method, the value of the asset is split evenly over the useful life of the asset. The value of the asset is calculated by subtracting the salvage value (scrap value) from the original cost incurred to purchase the asset. For example, if an equipment is bought for 10,000 euros, with a useful life of 10 years and a salvage value of 1,000 euros, the depreciation is computed as follows: Depreciation per year= (asset cost – salvage value) / useful life = (10,000-1,000) / 10 = 900 euros per year. Therefore, 900 euros will be written off each year for 10 years. 2. Declining balance depreciation The declining balance method of depreciation is an accelerated version of the straight-line method. Instead of an equal amount of depreciation for each year of useful life, unequal amounts depending upon the use are written off. In this method, more of the assets value is depreciated in the initial years than afterwards. This method is practiced by businesses who wish to recover maximum value upfront. For example, the equipment bought for 10,000 euros with a useful life of 10 years and salvage value of 1,000 will be depreciated by 20% each year, For first year, the depreciable amount will be (9,000*20%) = 1,800 euros For second year, the depreciable amount will be ((9,000-1,800) *20%) = 1,440 euros and so on. 3. Sum-of-the-years’ digits depreciation This method serves a similar purpose as the declining balance method. It allows to depreciate more in the initial years as compared to the later years. It is a bit more even in terms of distribution per year as compared to the declining balance method. The formula is as follows, (Remaining life in years / SYD) x (asset cost – salvage value) Where, SYD is the sum of the years of the asset’s useful life. SYD for an asset with a useful life of 4 years is equal to 11, which we get from (1 + 2 + 3 + 4). 4. Units of Production Depreciation A simple way to depreciate would be to quantify an asset’s use every year. For example, an equipment can be depreciated in proportion to the units produced. This is exactly what the units of production method of depreciation works. The formula is as follows, Depreciation: (asset cost – salvage value) / units produced in useful life. The number will vary each year, depending upon the use of the asset. How to file depreciation To claim depreciation expense on your tax return, you need to file IRS Form 4562. IRS Form 4562, Depreciation and Amortization, is used to depreciate or amortize property you’ve bought for your business. Once you understand what each part of this tax form does, you can plan ways to use it to reduce your tax burden. What do you need to fill out Form 4562 We’ll assume you’ve assembled all the records you need to file your income tax. On top of those, you’ll need the following to fill out Form 4562: • The price of the asset you’re depreciating • A receipt for the asset you’re depreciating • The date the asset was put into use (when you started using it for your business) • The total income you’re reporting for the year in question On top of that, if the asset you’re depreciating is being used for personal reasons, as well as business, you’ll need: • A breakdown, by percentage, of how often the asset is used for work, and how often for other reasons • Any records you have of asset use, such as mileage logs for a vehicle Form 4562 should be included as part of your annual tax return. You should file it for the same year you bought the property you’re planning to depreciate or amortize. Resources: https://bench.co/blog/tax-tips/depreciation/ https://www.meruaccounting.com/blog/depreciation-and-its-accounting/ HTH & Accounting Associates help organizations and business owners with accounting and/or financial consulting services. For Help with accounting or Bookkeeping contact us at accounting@thaddeus.org or call us at 909-599-2111. Thanks for reading Harshal Choudhari
March 21, 2022

What is depreciation?

Depreciation is the process of deducting the total cost of something expensive you bought for your business. But instead of doing it all in one tax year, you write off parts of it over time. When you depreciate assets, you can plan how much money is written off each year, giving you more control over your finances.

How To Account For It?

We debit depreciation every year from the asset account up to the estimated life of the asset. it is a non-cash transaction, so it does not directly affect the net income of the company. We pass a journal entry every year debiting the depreciated amount from the machinery account. However, we calculate the amount of depreciation at the time of purchase of the asset. We calculate it through the following method:

Depreciation = total cost of asset/ estimated life of the asset
Journal entry we pass for depreciation goes like this:
Depreciation a/c Dr.
To Machinery a/c
Depreciation is charged up to the years of estimated life until the original value completely gets eliminated.

What kind of assets can you depreciate?

The IRS sets guidelines for what types of assets you can depreciate. It needs to meet the following criteria:

  • You own it
  • You use it in your business, or to produce income
  • You can determine its useful life
  • You expect it to last more than one year

Some common examples of assets depreciated by small businesses include:

  • Vehicles
  • Real estate
  • Equipment
  • Office furniture
  • Computers

What is a depreciation schedule?

A depreciation schedule is a table that shows you how much each of your assets will be depreciated over the years. It typically includes the following information:

  • A description of the asset
  • Date of purchase
  • The total price you paid for the asset
  • Expected useful life
  • Depreciation method used
  • Salvage value–how much you can sell it for once it’s past its useful life (e.g., how much a scrapyard would pay for your old work truck)

How do I calculate depreciation?  

You can calculate depreciation in several ways. Generally, you take the original cost of the asset and subtract the salvage value. Then divide that number by the years you expect the asset to be useful. The IRS determines useful life based on a schedule set up for various assets.

You can include a specific amount on your business tax return as an expense during each year of the asset’s useful life.  

There are different methods you can use to calculate depreciation:  

  • Straight-line basis
  • Declining balance  
  • Double declining  
  • Units of production  
  • Sum-of-the-years’ digits  

Each method calculates depreciation expenses differently.

1.     Straight-line depreciation

Straight-line is one of the simplest methods of depreciation. In this method, the value of the asset is split evenly over the useful life of the asset. The value of the asset is calculated by subtracting the salvage value (scrap value) from the original cost incurred to purchase the asset. For example, if an equipment is bought for 10,000 euros, with a useful life of 10 years and a salvage value of 1,000 euros, the depreciation is computed as follows:

Depreciation per year= (asset cost – salvage value) / useful life
= (10,000-1,000) / 10
= 900 euros per year.
Therefore, 900 euros will be written off each year for 10 years.

2.     Declining balance depreciation

The declining balance method of depreciation is an accelerated version of the straight-line method. Instead of an equal amount of depreciation for each year of useful life, unequal amounts depending upon the use are written off. In this method, more of the assets value is depreciated in the initial years than afterwards. This method is practiced by businesses who wish to recover maximum value upfront. For example, the equipment bought for 10,000 euros with a useful life of 10 years and salvage value of 1,000 will be depreciated by 20% each year,

For first year, the depreciable amount will be (9,000*20%) = 1,800 euros
For second year, the depreciable amount will be ((9,000-1,800) *20%) = 1,440 euros and so on.

3.     Sum-of-the-years’ digits depreciation

This method serves a similar purpose as the declining balance method. It allows to depreciate more in the initial years as compared to the later years. It is a bit more even in terms of distribution per year as compared to the declining balance method.

The formula is as follows,
(Remaining life in years / SYD) x (asset cost – salvage value)
Where, SYD is the sum of the years of the asset’s useful life. SYD for an asset with a useful life of 4 years is equal to 11, which we get from (1 + 2 + 3 + 4).

4.     Units of Production Depreciation

A simple way to depreciate would be to quantify an asset’s use every year. For example, an equipment can be depreciated in proportion to the units produced. This is exactly what the units of production method of depreciation works.

The formula is as follows,
Depreciation: (asset cost – salvage value) / units produced in useful life.
The number will vary each year, depending upon the use of the asset.

How to file depreciation

To claim depreciation expense on your tax return, you need to file IRS Form 4562.  IRS Form 4562, Depreciation and Amortization, is used to depreciate or amortize property you’ve bought for your business. Once you understand what each part of this tax form does, you can plan ways to use it to reduce your tax burden.

What do you need to fill out Form 4562

We’ll assume you’ve assembled all the records you need to file your income tax. On top of those, you’ll need the following to fill out Form 4562:

  • The price of the asset you’re depreciating
  • A receipt for the asset you’re depreciating
  • The date the asset was put into use (when you started using it for your business)
  • The total income you’re reporting for the year in question

On top of that, if the asset you’re depreciating is being used for personal reasons, as well as business, you’ll need:

  • A breakdown, by percentage, of how often the asset is used for work, and how often for other reasons
  • Any records you have of asset use, such as mileage logs for a vehicle

Form 4562 should be included as part of your annual tax return. You should file it for the same year you bought the property you’re planning to depreciate or amortize.

Resources:

https://bench.co/blog/tax-tips/depreciation/

https://www.meruaccounting.com/blog/depreciation-and-its-accounting/

HTH & Accounting Associates help organizations and business owners with accounting and/or financial consulting services.

For Help with accounting or Bookkeeping contact us at accounting@thaddeus.org or call us at 909-599-2111.

Thanks for reading

Harshal Choudhari