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Understanding Depreciation:
It May Be More Simple Than You Think |
by:
John Day |
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.
About the author:
John W. Day, MBA is the author of two courses in accounting basics
for non-accountants. Visit his website at http://www.reallifeaccounting.comto
download for FREE his 3 e-books pertaining to small business accounting
and his monthly newsletter on accounting issues. Ask John questions
directly on his Accounting for Non-Accountants blog .
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