Depreciation affects your bottom line, your tax bill, and the value of your business. Those are three good reasons to learn what depreciation is and how it works. Here are the basics.
What is depreciation?
Depreciation is what happens when a business asset
loses value over time. A work computer, for example, gradually depreciates from
its original purchase price down to $0 as it moves through its productive life.
There
are techniques for measuring the declining value of those assets and showing it
in your business’s books. This area of accounting can get complex so it’s a
good idea to work with a professional.
Purpose of depreciation: 3 main functions
Depreciation
accounting helps you understand the true cost of doing business (because wear
and tear is an expense), reduce your tax bill, and estimate the value of your
business.
1. Depreciation as an expense (cost of doing
business)
To understand how profitable your business is, you
need to know all your costs. Depreciation is one of those costs because assets
that wear down eventually need to be replaced.
Depreciation
accounting helps you figure out how much value your assets lost during the
year. That number needs to be listed on your P&L report, and subtracted
from your revenue when calculating profit. If you don’t account for
depreciation, you’ll underestimate your costs, and think you’re making more
money than you really are.
2. Depreciation and tax
Because depreciation lowers your profit, it can
also lower your tax bill. If you don’t account for depreciation, you’ll end up
paying too much tax.
You
can gradually claim the entire value of an asset off your tax. However there
are rules around how quickly you can depreciate certain assets from a tax
perspective.
3. Valuing your business (depreciation on the
balance sheet)
As
assets lose value, so can your business. A transport company with old
trucks may not be worth as much as a transport company with new trucks, for
example. Your assets are listed on your balance sheet, on what is called the
fixed asset register. Make sure you update the register whenever you work out
depreciation. It’s also worth remembering that assets are often used to secure
loans. As they drop in value, they offer less security, and you may find it
more difficult to get finance.
What can be depreciated?
While
most business expenses are tax-deductible, they’re not all depreciable. There’s
a difference. Consumables like stationery can be deducted from tax but you have
to claim for them in the year you bought them. For most businesses, only fixed
assets can be depreciated.
What are fixed assets?
A fixed asset is something that will help you
generate income over more than a year. It includes things like tools,
machinery, computers, office furniture, vehicles, and buildings. You don’t
always have to own them. Some leased items may be depreciable, too.
Intangible assets, which are non-physical things
like patents and copyrights, can also be depreciated (or amortised). They’re
incredibly valuable to your business and that value gradually shrinks as they
near their expiry.
If
an asset doesn’t lose value – such as land – then it can’t be depreciated. Nor
can inventory. That is dealt with separately, under the field of inventory accounting.
Choosing a depreciation schedule
To depreciate an asset, you must first estimate its
lifespan. A computer might only last three years. A kiln in a factory could
last 30. You’ll probably find that the IRD has a depreciation schedule for the
types of assets in your business. It’s common for small business owners to
simply follow those recommendations.
An
asset’s value can be adjusted to zero at any time if it’s lost, stolen or
damaged. It can also be sold, traded or combined into a new asset.
Methods of calculating depreciation
You
also need to decide how an asset’s value will decline over its lifespan. Will
it lose most of its value early, or will it lose value at the same rate every
year? There are many different methods of calculating depreciation, and some of
them are quite complex. Three of the most common are:
Straight line depreciation
Under
this method, the asset depreciates the same amount every year, till it has zero
value. For instance, an asset expected to last five years would depreciate by
one-fifth of its ticket price each year.
Diminishing value depreciation
Under
diminishing value depreciation, an asset loses a higher percentage of its value
in the first few years. That rate of depreciation gradually slows down as time
goes on.
Units of production depreciation
The
lifespan of some assets is better measured by the work they do than by the time
they serve. For example, a vehicle might travel a certain number of kilometres,
or a packaging machine might box a certain number of products. You could
depreciate these assets based on usage rather than age.
Depreciation for small business
Depreciation can seem tricky at first, but it’s
nothing to be scared of. It will help you better understand your costs and
lower your tax bill, which are good things.
It
doesn’t have to be complex either. Most businesses simply adopt the
depreciation schedule provided by the IRD. Once it’s set up in your accounting
software, the maths happens automatically and the numbers flow straight through
to your tax return. And, as always, an accountant or bookkeeper can provide
advice along the way.