Some expenses, like office supplies, payroll, and inventory purchased for resale, benefit your business in the short term. The benefits of other purchases, like equipment, buildings, furniture, and computers, last much longer. Depreciation is a way to spread out those long-term expenses over a number of years on your financial statements. Rather than immediately recording the expense of a $10,000 machine, for example, depreciation could allow you to record $1,000 once a year for 10 years.
Depreciating your assets takes a little extra time and record keeping, but it can help you better understand your profitability and avoid misleading accounting losses on your income statement.
When You Need to Depreciate
Unless you follow generally accepted accounting principles, you don’t need to depreciate your assets for your financial accounting records. However, businesses do need to depreciate for tax purposes if asset purchases exceed a certain threshold. Section 179 of the tax code allows businesses to immediately expense $25,000 of asset purchases. That means business owners don’t need to use tax deprecation if total asset purchases are less than $25,000. To aid small businesses, Congress upped the limit from $25,000 to a whopping $500,000 for 2014 but hasn’t confirmed any increase yet for 2015.
Why Choose to Depreciate?
You may want to depreciate even if you don’t have to. That’s because immediately expensing large purchases wreaks havoc on your income statement. If the asset cost is large enough, it can create an artificial loss for that year. To make matters worse, it can take a few months or even years for equipment to start generating revenue for a business, exacerbating losses. Depreciating these assets smooths your business income so you don’t see those peaks and valleys in your financials.
Smoothing your income isn’t just about making your financials appear consistent. Depreciating assets also gives you a better sense of how much it actually costs to run your business and sell products. If you expense operating assets right away, you won’t see that expense listed in subsequent months once that equipment starts to support or produce revenue. This artificially inflates income for those subsequent months and, if you’re not paying attention, can cause you to overestimate the profit margin from your sales. By spreading out the expense of asset purchases, depreciating them gives you a better sense of your true monthly profit.
How to Depreciate
GAAP offers business owners a handful of depreciation methods to choose from. The most straightforward of these is straight line depreciation. The annual depreciation expense under the straight line method is the asset cost minus any salvage value divided by the number of years you expect it to be in service. For example, if you buy a machine for $5,000 and expect you can sell it for $2,000 in five years, the straight line depreciation is $3,000 over five years ($600 each year).
Add an asset to your balance sheet when you initially purchase the item. As you record depreciation expense, accumulated depreciation will increase correspondingly. This accumulated depreciation account is noted on the balance sheet and decreases the value of the asset. For example, if the asset cost $5,000 and you’ve recorded $600 of accumulated depreciation, its net value on the balance sheet will be $4,400.
Your accountant can help you explore other depreciation strategies.
If you exceed the Section 179 limits, you’ll have to depreciate a portion of your assets for tax purposes. The IRS doesn’t allow many of the standard methods of depreciation used in financial accounting. This can be frustrating, but it can also work to your advantage. When it comes to taxes, most business owners want to claim expenses as soon as possible to reduce taxable income and tax liability. Your tax accountant can use an accelerated depreciation method called MACRS to get you a bigger deduction right away.