Most businesses rely on at least some physical assets to stay operational. Unfortunately, even the highest-quality equipment doesn’t last forever. Because computers, cars, office equipment and machinery all lose value as time goes on, businesses need a way of recording this loss in their books.
Quantifying that loss is known as depreciation, which refers to the portion of an asset’s cost that is “consumed,” or transferred from balance sheet to income statement, in a given accounting period. In this way, businesses are attributing a portion of the profits from a physical asset to a portion of its expense.
It’s easy to confuse depreciation with amortization. Quite simply, depreciation refers to tangible assets, like those listed above. Amortization refers to intangible assets, like intellectual property, contract rights or other intangible assets with a fair market value.
In calculating depreciation, there are three factors to consider.
- Useful life: refers to the time period that the asset can be used until it doesn’t function.
- Salvage value: which refers to the amount of money a company can hope to recover by selling the asset.
- Obsolescence: companies must assess if and when an asset will become obsolete and need replacement.
These three factors will also be defined against your asset’s purchase price.
It’s important to note that depreciation is calculated based on the historical value of an item and its likely lifespan, as opposed to the cost of replacing it now. While the market value of assets like computers and machinery tends be less than the recorded amount, the market value of property can often be higher than the value listed on the balance sheet.
Additionally, companies should note that not all assets depreciate. Items predicted to last a year or less are not eligible for depreciation. Further, because only asset owners can claim depreciation, leases on assets you don’t own (e.g. buildings, cars) are not allowed.
Recording Depreciation in Accounting and Taxes
Businesses record depreciation by debiting the depreciation expense accounts of their income statements and crediting the accumulated depreciation accounts. As assets continue to depreciate, the accumulated depreciation balance will rise until it equals the purchase value of the asset in question. When the asset cost arrives at a zero value, businesses can stop recording depreciation.
Companies use various methods to calculate depreciation. Under the accelerated method, businesses acknowledge more depreciation at the start of an asset’s lifespan in order to delay income tax recognition. In this case, they will need to pay more taxes later on.
On the other hand, the straight-line method utilizes a steady depreciation model that is often easier to calculate. To determine depreciation expense with the straight-line method, use the following formula:
Depreciation expense = (asset purchase price – salvage value) / useful life.
IRS Rules for Recording Depreciation
When recording depreciation on income tax returns, it’s important to follow the IRS guidelines to the letter. In some cases, the IRS predetermines an asset’s lifespan, so it’s important to inquire about this ahead of time.
Additionally, the IRS permits businesses to utilize a 10-year straight-line assumption for their accounting books while employing a 7-year accelerated option for their income tax returns. Finally, there are cases in which companies can expense the entire cost of an item—up to a certain dollar amount—at the time of purchase. Businesses can visit the IRS website for specific rules and guidelines regarding their particular situations.
If you’re looking for more information on how other types of valuation might affect your business, check out our articles on accounting for business goodwill and how to valuate your early-stage business.