What is Depreciation?
Depreciation is the accounting way of measuring the wear and tear on your fixed assets. Though it has no impact on cash, it is part of your expenses. That means depreciation lowers your company’s net income, which also means a lower income tax bill.
Unlike expenses, when you buy assets you don’t get to deduct them right away, even though they have taken up a portion of your cash or increased your liabilities. Taking depreciation expense allows you to deduct that asset over time, as you use it to help produce revenues.
During the life of a usable physical asset, depreciation is used to spread out its price. For accounting and tax purposes, businesses depreciate assets.
Depreciation can also occur as a result of poor market conditions. As far as accounting and taxation are concerned, depreciation demonstrates the amount of value utilized for an asset.
Though there are several different ways to depreciate assets, the two most often used by small businesses are:
- Modified Accelerated Cost Recovery System, or MACRS method (also called the tax method)
- The straight-line method
Both methods are acceptable for use on your business tax return. Although you can use one method for book purposes and another for tax purposes (and you have to report that fact to the IRS), it’s easier to keep your books and tax records the same way. The main difference is that MACRS lets you take bigger depreciation deductions sooner than you would using the straight-line method (that’s where the “accelerated” comes from); overall, though, the total depreciation over the life of the asset will be the same.
Whichever method you choose, you’ll need some basic pieces of information to get started: the asset cost, purchase date, useful life, and what percentage the asset is used exclusively for the business. If the asset won’t be used 100 percent by the business, you can only depreciate the portion used by the company. For example, if you have a laptop that you use both for business and personal reasons, you must estimate the percentage of business use; if the business use is 80 percent, you can only deduct 80 percent of that year’s total depreciation calculation for the business.
Let’s take a closer look at each type of method.
MACRS is what the IRS wants businesses to use for calculating depreciation. Under this method, all assets are lumped into categories called property classes, and each property class comes with a specific depreciation schedule. For example, all office furniture is considered seven-year property, while all computers are considered five-year property. Each property class comes with its own preset annual expense percentages schedule (the percentages change every year). You can download a complete copy of the table from the IRS website (www.irs.gov). The MACRS asset categories and depreciation schedules are surprisingly clear and simple to use.
In most cases, you’ll use the “half-year convention” table. The basic point of this table is to help you properly calculate depreciation, because no business buys all of its assets on January 1. The half-year convention assumes that all new assets were purchased at mid-year, and gives them all 50 percent of the full depreciation for the first year; it then allows for the full-year expense going forward. You’ll notice that the tables have an extra year built in; three-year assets have four years of percentages, for example. That’s to account for the half year at the end of the asset’s life to make up for the missing half year at the beginning.
Here’s how MACRS depreciation works. First, you figure out which category your asset belongs in, according to the IRS chart. Then you look up the percentage for this year in the asset’s life. For instance, if it’s the second tax year you have the asset, use the percentage for year two. Finally, you multiply the total original asset cost by the percentage from the chart. If the asset isn’t used exclusively for business, you have to take an extra step and multiply the business-use percentage by the depreciation amount you just calculated.
Straight-line depreciation is usually an acceptable option for most assets, even though the IRS prefers MACRS. Though this method gives you a lower depreciation expense up-front, the annual deduction remains steady over the life of the asset. This method also gives you bigger deductions than MACRS in later years.
The calculation for straight-line depreciation is straightforward. Take the total original cost of the asset and divide that by the asset’s useful life (usually taken from the MACRS asset class listing). The result is the annual depreciation expense, which is the number you’ll use every year except the first and last. For those years, you can go with 50 percent, to mimic the half-year convention, or you can figure out the true proportion, what percentage of the year you actually owned the asset.
For example, if you bought the asset in February, you could multiply the total expense by 10/12 because your company will have used the asset for 10 out of 12 months during the first year; you would use 10 instead of 11 because March would be the first full month the asset was in use.
Amortization expense is similar to depreciation, except it’s only used for intangible assets. This expense measures a decline in the value of those assets over time. How do intangible assets decline in value? Well, they don’t wear out or rust, but some of them, such as patents, have specific end dates. Others, such as licensing agreements, come with clear useful lives. Also, according to IRS regulations, a company can’t amortize an intangible asset (like a copyright or patent) that it created, only those that it purchased.
The running total of amortization expense is sometimes (but not always) held in a contra account, which generally is called accumulated amortization. The reasoning here is the same as it is for depreciation: This allows you to see the original value of the asset separately from how much of it has been “used up.” For amortization, though, you actually have another choice, which you don’t have for depreciation: You can record amortization directly to the intangible asset account instead of using the contra account, saving you extra bookkeeping work at the end of the accounting period.
Unlike depreciation, the amortization can only be calculated on a straight-line basis. That means for each period the exact same amount is booked to expense until it’s all used up. If your company bought a patent for $15,000 that had 15 years left until expiration, you would amortize $1,000 per year for 15 years.
You can’t amortize any intangible asset over more than 15 years, even if it has a much longer legal or useful life. If the asset’s useful or legal life is shorter than 15 years, though, you have to use that shorter time span when you figure out the expense.
Though it may seem as though amortization won’t apply to your company, it probably will. The most common amortization expense for small businesses is startup costs. While you’re doing all the things you have to do to get your business started, there’s no actual business for which you can deduct those expenses.
Instead, you have to lump the expenses into an asset and amortize them over five years. Expenses you would typically put into this account include legal fees, business licenses, and incorporation fees (or the equivalent for LLCs or partnerships)—any expense you incur to create the company.