Depreciation is a fairly simple concept. When a business owner buys a fixed asset, that asset loses its value over time, and so its most current value must be accounted for on the company's balance sheet. A computer bought in 2008 for $2,000, for instance, can't be listed on a company's balance sheet in 2011 as an asset valuing $2,000 (and doing so would constitute fraud).
In order to calculate basic depreciation, a company just needs two numbers: the initial cost of the asset and its estimated "useful life." The straight-line method of calculating depreciation would be to divide the initial cost by the asset's useful life. So if a company buys a machine for $100,000, and its useful life is determined to be 10 years, it depreciates in value by $10,000 every year.
Amortization is similar to depreciation in that both are a form of a write-off, but amortization refers to exclusively intangible assets (company goodwill, research and development) while depreciation refers specifically to tangible goods. Land, it should be mentioned, does not depreciate on a company balance sheet.
Though accounting for depreciation is a relatively straightforward process handled by accountants, some small business owners that take a DIY approach should know about a couple of recent changes to tax laws that have implications for how a business should choose to depreciate its assets. There's also a few tools that exist to help calculate the depreciation metric.
Recent legislation that affect small business
In December 2010, President Obama signed into law The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act. The legislation extended the SmallBusiness Jobs and Credit Act's "bonus depreciation" allowance through the end of 2011, which allows a business owner to write off an entire purchase during the year in which it was bought.
So, in the example mentioned above, the machine would not have to depreciate over 10 years; rather, the act allows the company to write it off in full in the first year its purchased. The act is intended to stimulate purchases of capital goods, since it allows small businesses a way to deduct more on their taxes than the traditional straight-line method allows for. This type of tax scheme is referred to as "accelerated depreciation."
Salim Omar, an accountant and president of the Omar Group, a tax consulting firm in New Jersey, says that small businesses can get tripped up when deciding how to use this new type of credit.
"To decide whether to take it or not depends on what the business plans to due in the future," he says. "It's important think through whether or not they're going to be in a higher tax bracket in future years, because if they are, then it may not make sense to take the whole benefit in the first year."
More information about the Bonus Depreciation and Increased Section 179 Deduction under the American Recovery and Reinvestment Act can be obtained here.
Depreciation tools and resources
There are several common mistakes small business owners make when calculating depreciation, including math errors, deducting instead of depreciating, and using the wrong "useful life" metric. Here's a few tools to make sure the calculations check out:
- The Depreciation Calculator Spreadsheet, provided by Inc.com, is used by companies for to calculate depreciation. The spreadsheet is customizable, with columns for initial value, estimated salvage value, useful life, and estimated productivity capacity.
- Depreciating property can be especially tricky. The IRS provides a number of resources to help business owners figure navigate this process. Publication 946 is the IRS official guide on calculating
- A number of apps also exist to calculate depreciation when you’re not in front of a computer. Business Compass LLC offers a popular Depreciation app, available for Android and iPhone.