Most people are confused about “what is Depreciation?” It’s a method of accounting that distributes the expense of an asset across its estimated life. Depreciation is a periodic expense that businesses record on their income statement. As assets depreciate, their value decreases over time.
You are here because you have questions about “what is Depreciation?”. We will be discussing everything you need to know about depreciation, including the different types.
What Is depreciation?
There are two major aspects to depreciation. The first is the gradual decrease in asset value over time. The second aspect involves allocating the original price paid for an asset over the time it is used.
The estimated useful life, or the time the asset can be used, determines how many years an asset will depreciate. The estimated useful life of a laptop is five years, for example.
Assets can be classified as commodities or property. Asset depreciation can be included in your annual budget or balance sheet. However, it is not considered a fixed expense unless the method you use changes each year (such the unit of production), then it would be considered variable.
Different Types of depreciation
Accounting uses many methods of depreciation. These are the four major types of depreciation.
This is the easiest and most straightforward way to depreciate. This method divides the asset’s worth equally over multiple years. It means that you pay the same amount each year the asset is in use.
Straight-line Depreciation is a great option for small businesses that have simple accounting systems, or where the tax return is filed and prepared by the business owner.
Straight-line depreciation has many advantages. It is simple to use, produces few errors and can be expensed by business owners every accounting period.
Its simplicity can be a disadvantage, as the useful life calculation is largely based upon guesswork or estimation. The asset’s age and potential loss in value over time are not included in this calculation.
This is also known as declining balance depreciation. It allows you to write down more of an asset’s worth right after it’s purchased and less over time. This option is great for small businesses who want to recover more value immediately, rather than waiting for a set number of years.
Double-declining balance is advantageous because it can offset higher maintenance costs as assets age; it can also maximize tax deductions, allowing for higher depreciation expense in the early years.
You won’t be able to take an additional tax deduction if your company has suffered a tax loss in a previous year.
Sum of the years’ digits depreciation
Sum of the years’ numbers (SYD), depreciation is similar in nature to double-declining. However, it also includes an accelerated calculation. SYD does not decrease the asset’s book value. Instead, it calculates a weighted percentage that is based on its remaining useful life.
SYD is a good option for businesses who want to recover more value immediately, but with a more even distribution than what they would get using double-declining. SYD has the advantage of reducing taxable income and taxes due in the first years of an asset’s life. SYD is more difficult to calculate than other methods.
Units of production depreciation
This is an easy way to reduce the asset’s value based on its frequency of use. The equipment’s “units of production” can refer either to the amount of pizzas it can make or how many hours it is used. This is a good option for businesses who want to write off equipment that has a quantifiable, widely accepted (based on manufacturer’s specifications) output over its useful life. You should have a system in place to track your equipment use and expect to write off an additional amount each year.
The units of production method has the advantage that it provides a very accurate picture of your depreciation costs based on actual numbers depending on how you track them. The main drawback is that it can be difficult to apply in real-life situations. It isn’t always easy to determine how many units an asset will produce before it ends its useful life.
How Does Depreciation Affect Tax Liability?
By tracking the decline in your assets’ value, depreciation lowers taxes that your business must pay. Depreciation expenses for your business reduce the earnings upon which your taxes are calculated, which in turn reduces the tax your business owes to the IRS. Your taxable income will be lower the higher your depreciation expense.
How Are Assets Depreciated for Tax Purposes?
When people refer to accounting deduction, depreciation is often the first thing they think of. This is how an asset’s costs are allocated over its useful life to align their expenses with revenue generation.
Accounting depreciation plans are also created by businesses with tax benefits in view. Asset depreciation is deductible as a business expense according to IRS rules.
We’ve already covered everything you need to know about depreciation, including the types. We hope you find our blog helpful and that it clarifies all your questions about “what is depreciation?”