|
Understanding Depreciation: It may be more simple than you think
by John Day
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).
| 
Free Downloads
Career
RSS Feed