The topic of depreciation can be tricky for anyone who is not an accountant. After all, the idea of an asset depreciating in value may not sound like good news. However, the benefits of annual depreciation expense become clearer to small and midsize businesses once their tax bill arrives.
Even if the accounting team spearheads all things depreciation, small and midsize business owners should familiarize themselves with the basics of depreciation and understand how it impacts asset values and company financial statements.
What is depreciation?
Depreciation is a standard accounting practice of allocating the cost of an asset over its useful life.
It relies on the premise that businesses purchase many items that are useful for more than just one year. However, those assets will lose value over time as they become outdated or incur regular wear and tear.
An example people are often familiar with is purchasing a new vehicle. As soon as you drive it off the lot and continue to put miles on it, it becomes less valuable than when it was initially purchased.
Thus, depreciation expense allows businesses to reduce the value of an asset each year to account for its obsolescence or wear and tear. This annual expense reflects the asset’s actual usage and may help to reduce the business’s tax liability.
Why is depreciation expense important?
Depreciation expense represents a genuine reduction in the value of the asset being depreciated across a given accounting period. The Internal Revenue Service (IRS) allows companies to capture the tax benefits of this depreciation amount over the course of the asset's life. Claiming this depreciation expense reduces taxable income for the company across the asset's useful life.
The impact of depreciation on business finances
While depreciation can provide attractive tax advantages, this does come with the tradeoff of a lower net income reported on the profit and loss statement.
Each year, the depreciation expense decreases the business’s taxable income, which could lower its tax burden. All else being equal, the larger the depreciation expense, the more it could reduce a business’s tax bill.
Depending on the expected useful life of the asset, this means businesses could continue enjoying tax-related benefits on the purchase even several years later. But, the business will also record lower profits in the meantime because of it.
Notably, depreciation is often considered a “non-cash expense” because it doesn’t reflect actual cash flows in the years following the initial purchase. However, it is treated as an expense in accounting records for tax-related purposes.
Understanding depreciation is important in accurately reflecting a company's expenses and net income for taxes, as well as calculating the remaining value of an asset: the current value of the asset minus the depreciable cost the asset loses over time.
According to the IRS, small businesses can depreciate the following assets:
- Machinery
- Equipment
- Buildings
- Vehicles
- Furniture
Notably, this list does not include land, which is not considered a depreciable asset. The value of land typically appreciates over time.
SMBs are also unable to claim depreciation on personal property. While this may seem obvious, there are certain scenarios where the lines can be blurred, like when a business owner uses their personal vehicle for work purposes. In this case, only the portion used for business reasons can be depreciated.
In any case, the IRS lays out a list of requirements that businesses must meet to depreciate property. This can help businesses further understand what qualifies as a depreciable asset. Such requirements include:
- The business must own the property (even if it’s financed)
- The asset must be used to generate taxable income
- The asset must have a defined useful life
- The useful life of the asset must be longer than one year
How do depreciation expenses work?
At a high level, depreciation expenses appear on the company's income statement, reducing the company's profitability. The particular way to calculate depreciation expense depends on the type of depreciation used, as covered below.
Depreciation expense vs accumulated depreciation
Depreciation expense is an expense that appears on the company's income statement. Accumulated depreciation appears instead on the balance sheet. It represents the accumulation of depreciation against an asset, or the total depreciation expense that has been claimed against that asset over time.
Types of depreciation
There are a few methods of depreciation, including:
- Straight-line depreciation method
- Double declining balance depreciation method
- Units of production depreciation method
The formula used to calculate depreciation will vary depending on the chosen method, which will also impact the expense amount that’s recorded.
Businesses generally have a choice over which depreciation method they will use. However, there are varying elements and characteristics of each method that make them better suited to certain situations. Here’s a closer look at each:
Straight-line depreciation method
The most common and straightforward way to calculate depreciation expense is the straight-line method of depreciation.
This is best for assets that consistently wear out over time, as the periodic depreciation expense will be the same each year until the end of its useful life.
Here’s the formula for the straight-line depreciation method:
Again, the application of this method is quite simple in practice. If a business purchases a piece of equipment that costs $45,000, with an estimated useful life of eight years and a salvage value of $0, the depreciation expense each year would be:
Depreciation expense = (45,000 – 0) / 8
= 45,000 / 8
= $5,625
Based on this calculation, the depreciation schedule would look like:
Double declining balance method
This accelerated depreciation method is a bit more involved than the straight-line method. It is best for assets that quickly lose value after purchase, allowing businesses to write off a larger portion of their value early on in their useful life and less in the later years. Thus, the yearly depreciation expense will decrease over time.
The formula for the double-declining balance method is as follows:
Where the rate of deprecation is:
= (100% / Useful life) * 2
As the name might suggest, the calculation assumes that the asset will depreciate at double the rate of the straight-line method.
If a business purchases a delivery van for $35,000, with an estimated useful life of 8 years and a salvage value of $3,500, it would first need to calculate the deprecation rate. This would be:
Rate of depreciation = (100% / 8) * 2
= (1 / 8) * 2
= 0.125 * 2
= 0.25
Using the depreciation rate of 25%, there’s a simple calculation to find the depreciation expense for the first year:
Depreciation expense = 35,000 * 0.25
= 8,750
In the following year, the lower starting book value would result in a lower depreciation expense, which would continue to decline over the years until reaching the salvage value, as illustrated in the following depreciation schedule:
Units of production method
Finally, the units of production method calculates the unit depreciation expense based on the amount of work the asset does. This could be the hours of work it’s in service or the number of widgets it produces.
Here’s the depreciation formula for using this method:
In this scenario, let’s consider the business purchasing a piece of equipment for $20,000 that has no salvage value and an estimated total production of 50 million units.
In the first year, it produces 4 million units, which would result in the following depreciation expense:
Depreciation expense = (4,000,000 / 50,000,000) * (20,000 – 0)
= 0.08 * 20,000
= 1,600
Thus, the depreciation expense will vary from year to year based on the actual production of the asset. Over time, the depreciation schedule might look something like this:
Understanding the depreciation schedule
As exhibited in the tables above, a depreciation schedule simply allows businesses to stay on top of planned depreciation expenses over the useful life of an asset.
It’s a simple resource used for internal record-keeping and decision making to understand how depreciation will impact accounting records to inform financial planning and budgeting decisions.
The schedule might look slightly different from business to business depending on the depreciation method chosen and other internal requirements.
How do you record depreciation expenses?
When a business buys a depreciable asset in a given year, it won’t record the full purchase price as an expense on the income statement during that reporting period.
Instead, the transaction will be recorded on the balance sheet as a debit to the asset account (like Property, Plant and Equipment) and a credit to the cash or accounts payable account.
At the end of the reporting period, the business will claim depreciation expense for any relevant assets using one of the accepted methods.
Depreciation journal entry example
The following journal entry corresponds to the initial asset purchase of a piece of machinery costing $25,000:
Then, using the straight-line method with $0 residual value and 10 years of useful life, the journal entry for recording depreciation expense at the end of the year would look like:
Gain better visibility into your business’s finances
Depreciation can be a powerful tool for businesses to spread the cost of fixed assets over their useful life, offering tax, accounting, and financial planning advantages.
For additional support managing business finances, turn to BILL. As an all-in-one financial operations platform, BILL helps businesses create and send invoices, pay bills, manage expenses, and access credit from within the same system.
Join BILL today to see how the platform can help you streamline accounts payable, accounts receivable, and spend management.
