What is consumption?

Definition and Examples of Depreciation

Depreciation is the process of allocating and claiming the cost of tangible assets over each fiscal year, spread out over their expected economic life. Depreciation involves the decrease in the value of an asset over time. To calculate depreciation, you need to know the asset’s salvage value (what it could be sold for) and its residual value (what it would be worth if it had no useful life). A company can deduct the cost of its depreciated assets for tax purposes by claiming them on its income tax return.

How Depreciation Works

Depreciation is the process of allocating and claiming the cost of tangible assets in a specific fiscal year, spread out over their expected economic life. Business owners can use depreciation to recoup some of the cost of an asset over its lifespan.

Types of Depreciation

Depreciation is a non-cash expense that can be deducted from taxable income. The IRS provides guidelines on how much depreciation can be taken on assets, and these guidelines depend on the asset’s expected lifespan. There are two common methods for calculating depreciation for small business assets: straight-line depreciation and declining balance depreciation.

Straight-Line Depreciation

The simplest and most commonly used method for calculating depreciation is “straight-line” depreciation. This type of depreciation is calculated by dividing the cost by the expected lifespan, resulting in equal expense for each year. The formula for this method is as follows:

Depreciation = (Cost – Salvage Value) / Useful Life

Declining Balance Depreciation

“Declining” or “double declining” depreciation is used for assets that have a faster expected depreciation rate. The double declining method more accurately represents the rapid depreciation of automobiles and thus can be used to match the cost with the benefit of using the asset. This type of depreciation is computed by multiplying the cost by the useful life fraction, yielding an equal expense each year.

Depreciation = 2 × Straight-Line Depreciation Rate × Book Value at Beginning of Period

It should be noted that not all assets or properties can be depreciated for business taxes. According to the IRS, the following items are exceptions to this specified tax deduction: assets used and disposed of in the same year, and equipment used to construct capital improvements. Capital improvements are typically made to enhance the overall value of property, extend its useful life, or adapt it for new uses. Intangible assets defined under Section 197 – such as goodwill, current workforce, business records, operating systems, patents, copyrights, and licenses or permits – must be amortized instead. Intangible property can be amortized if it meets specific requirements.

One of the most overlooked aspects of business is depreciation. It may not seem like an exciting topic, and it often gets forgotten until tax time, but depreciation is a fundamental part of how businesses calculate expenses and income. The IRS allows taxpayers who own depreciable assets as defined in Sections 1245 or 1250, such as machinery, furniture, and equipment, to take annual deductions for those assets on their tax returns.

Find the method that best fits your company’s assets (possibly with the help of an accountant) and ensure you are fully benefiting from this tax break.

Source: https://www.thebalancemoney.com/what-is-depreciation-5205651