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.
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:
Straight-line
This is the simple method mentioned in the definition above. Just
take the cost of the item, divide it by the useful life and you’ve got
the answer. Yes, you will have to adjust the depreciation for the first
year you placed the item in service and for the last year when you
removed the item from service. For instance, if your depreciation for
one year was $150 and you placed the item in service on April 1 then
divide $150 by 12 (months) and multiply $12.50 by 9 (months) to get
$112.50. If you removed the item on February 28 then your deduction will
only be $25.00 (2 x $12.50).
Double-declining balance
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.
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