When you hear the word depreciation, what comes to mind? Do
you think of the value of a car dropping as soon as you drive it off the lot?
Do you think of an item wearing over time? Or do you think of it is an
accounting term? Well, it is all three. And as a business owner, depreciation is
a critical feature of your business’s overall value. It describes the value of
an asset over time.
The balance sheet shows your business’s net worth, which
includes assets, liabilities, and owner equity. The value of an asset changes
over time and those changes are reflected in the financial statements. For an
asset to qualify for depreciation, the company must own the property, use it
for business or income-producing activity, have a determinable useful life and
last more than a year. These are considered long-term assets and can wear out,
become obsolete, and lose value from natural causes over time. Examples of
items qualifying for depreciation are office equipment, farm machinery,
vehicles, phones, office furniture, appliances, real estate (not land), etc.
For accounting purposes, there is depreciation “expense” and
accumulated depreciation “account”. On our financial statement, depreciation “expense”
lives in the income statement and is the expense recorded for the year.
Accumulated depreciation lives on your balance sheet. It’s what is called a
contra asset account, so it’s on the liabilities side of the ledger. Confusing?
Yes! Let’s make it simple. In this example, the asset will be office equipment.
The equipment’s purchase price was $10,000 and began it’s life on your
business’s balance sheet as an asset worth $10,000. However, over time, the value of the
equipment goes down as it gets older. So if you’re depreciating $1000 per year,
the equipment asset side drops to $9000 the first year and accumulated
depreciation on the liability side goes up by $1000. Those accounts continue to
balance each other year after year in this fashion.
It’s important to understand what these numbers mean even if
you use an accountant so you know how to read your own financial statements,
understand the tax implications of depreciation and the best time to purchase
assets, and have a realistic view of the value of your company.
As companies and people wish to reduce their tax liability,
understanding IRS depreciation codes is important. The IRS code requires
long-term assets expensed over the life of the item. A company can expense the
entire cost of an item in the first year by using Section 179; however, it will
depend on the type of product and when placed in service. Special rules for
depreciation apply to listed property, which includes cars, entertainment
property, and certain computers. Loading up all purchases in the 4th
quarter is not a great strategy. If more than 40% of items are purchased in the
last three months of the year, something called the mid-quarter convention
applies, which reduces the amount you can deduct that first year.
Planning requires an expert in taxes and allows a company to
minimize their tax liability and take advantage of IRS codes. Use BBB.org to
find a tax professional who is trustworthy and will guide you and your company.
Strategizing when to buy large ticket
items and if you should use section 179 or depreciate over the lifetime of the
product needs to be decided by looking at the overall financial picture.
Depreciation is a complicated topic; however, it impacts a
company’s tax liability and bottom line. Hiring a tax professional will help
your company strategize purchases, minimize taxes, and focus on the business at
hand, so your business value increases.