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.
(article continued below ...)
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:
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.
