Whether you operate as a large corporation or a small start-up, depreciation is an incredible tool to ensure that valuations of your business, both internally and externally, are representative of the entire operations of the business. This assists when getting funding from venture capitalists, or even when running finances within the organisation.
What is depreciation?
The process of depreciation occurs when the value of an asset decreases over time. As a result, businesses must determine whether the overall value of an asset is worth the cost to the business. This can be completed by allocating the original price of the asset over the period of time that the asset is used. An example of this happening in the workplace may include the cost of machinery, the value gradually depreciates from its original cost down to $0 as it continues to operate.
There are several techniques to measure the decline in the value of assets and auditing these costs, however, some techniques can get extremely complex, so it is recommended to work with a professional, or use detailed templates such as Business Kitz’ Bookkeeping and Accounting Kit.
What is the purpose of depreciation?
Depreciation is essential for businesses to help to determine the cost of an asset compared to the benefit of its use over time and to match the expense recognition for an asset to the revenue generated by that asset. The ‘matching principle’ is where revenues and expenses both appear in the income statement in the same reporting period, giving the best view of how well a company has performed in a given reporting period.
- The cost of depreciation
Ultimately, depreciation can create a significant expense to a business as there becomes a repetitive need to replace assets due to their extensive use. The overall loss of value should therefore be calculated throughout the year to list on the companies profit and loss statement, and subtract from revenue when calculating profit. Without the calculation of depreciation, a company would underestimate its costs, resulting in a false revenue prediction.
- The tax of depreciation
Without the integration of depreciation within a businesses financial analysis, the business will pay too much tax.
- Business valuation
When it comes to valuing your business, the loss in value of an asset results in loss in value of a business. It is important to list assets from your balance sheet on a ‘fixed asset register’, which can be updated once the depreciation is calculated.
What are the methods of calculating depreciation?
Straight line depreciation splits an asset’s value equally over multiple years, meaning cost remains the same every year of the asset’s life. This is valuable for small businesses who use simple accounting systems or businesses where the business owner prepares and files the tax return.
- Advantages
- Easy to use
- Minimal errors
- Business owners can expense the same amount every accounting period
- Disadvantages
- The life calculation is based on an estimation and may not be entirely accurate
- Does not consider any accelerated loss of an asset’s value in the short term or the increase in maintenance costs over the assets life.
Formula = (Cost of asset – Salvage value of asset) / Useful life of asset = Depreciation expense.
Double declining depreciation allows you to write off more of an asset’s value right after you purchase it and less as time goes by.
- Advantages
- Can help reduce any increased maintenance costs as an asset ages
- Maximises tax deductions by allowing higher depreciation expenses in the early years
- Disadvantages
- Won’t benefit from additional tax deduction if your business already has a tax loss for a given year
Formula = 2 x (single-line depreciation rate) x (book value at beginning of the year) or use a double declining calculator.
This depreciation method is used instead of decreasing book value. Sum of the years (SYD) is a calculated weighted percentage based on the asset’s remaining years of use.
- Advantages
- The accelerated depreciation reduced taxable income and taxes owed during early years of asset’s life
- Disadvantages
- Complex to calculate in comparison to other methods
Formula = (Remaining lifespan / SYD) x (Asset cost – Salvage value)
This type of depreciation is used when the value of an asset is based on how frequently the asset is used. This method refers to something the equipment makes and the quantifiable value it delivers e.g. how many trips a company car can offer.
- Advantages
- Provides a highly accurate picture of the depreciation cost based on actual numbers
- Disadvantages
- This method can be difficult to apply to real-life situations, as it is not always easy to estimate the amount of units an asset can produce before it reaches the end of its life.
Formula = (Asset cost – Salvage value) / Units produced in useful life
What can be depreciated?
A fixed asset is classified as something that will assist in generating income for more than a year. Intangible assets including patents and copyrights can be depreciated as the value gradually decreases as they near expiry. Tangible assets include items such as:
- Machines
- Vehicles
- Office buildings
- Buildings you rent out for income (residential and commercial property)
- Other equipment (incl. computers and other technology)
What assets cannot be depreciated?
There are some assets a business may hold that cannot be depreciated. This is due to the fact that they may not lose value over time, and therefore do not accumulate cost to the business.
- Land
- Collectibles like art, coins, or memorabilia
- Investments like stocks and bonds
- Buildings that you aren’t actively renting for income
- Personal property, which includes clothing, and your personal residence and car
- Any property placed in service and used for less than one year
What are fixed assets?
A fixed asset is classified as something that will assist in generating income for more than a year. This may include tangible assets such as tools, computers, machinery, vehicles etc. These may also include leased items. Intangible assets including patents and copyrights can also be depreciated as the value gradually decreases as they near expiry.
Legal advice
If you are unsure about how to best protect your business when it comes to depreciation and following tax obligations, Legal Kitz can assist you. To arrange a FREE consultation with one of their highly experienced solicitors, click here today, or contact us at [email protected] or 1300 988 954.