Depreciation is one of those concepts that many small business owners think they should know and understand, but not all of them do. If you are a small business owner, then there are a number of key reasons why you really should understand depreciation. Here is a breakdown of what depreciation is and why you need to understand it fully.
What is Depreciation?
Depreciation is the gradual decrease in value that occurs to various assets over time. Not all assets depreciate. Land, for example, is not considered a depreciating asset. This is because the value of land tends to go up in value over time, not down.
Cars and machines, however, are considered depreciating assets. When an asset experiences a significant amount of depreciation, its value can decline substantially. For example, a new car will depreciate by roughly 20 percent in the first year of ownership! After five years, a new car will depreciate by roughly 60 percent and will only be worth about 40 percent of the purchase price.
What Types of Business Assets Depreciate?
Many different types of business assets can experience depreciation. For example:
- Office Furniture
- Improvements to Buildings
- Leasehold Improvements to Rented Property
- Business Vehicles
- … and more
All of these assets tend to decrease in value over time. This is mostly due to either wear and tear or to becoming outdated. For example, a computer can break down after a number of years, or it can simply become obsolete due to advancements in technology that result in new and improved computers.
What Types of Business Assets are Not Considered Depreciable?
Despite the fact that many business assets are considered depreciable, many are not. For example, all of the following assets are not considered to be depreciable:
- Leased Property
- Collectibles, such as coins, cards, and art
- Current assets, such as cash in hand, receivables
- Investments such as stocks and bonds
- … and more
Why Do Small Business Owners Need to Understand Depreciation?
The main reason why small business owners need to understand depreciation is because if they do, they can save a significant amount of money in taxes. This is because, under the United States tax code, depreciation can be deducted as a business expense. So, business owners who understand depreciation and how to calculate it can experience a dramatically reduced tax bill at the end of the year. This is especially true if the business owner has many assets that fall into the depreciable category.
How is Depreciation Calculated?
There are a number of different methods for calculating depreciation. For example, all of the following methods are commonly used to calculate depreciation:
- Straight-Line Method
- Units of Production Method
- Sum-of-Years Digits Method
- Double-Declining Balance Method
However, of all of these methods, the Straight-Line Method is the method that is most commonly used. The formula for the straight-line method is:
(asset’s historical cost – the asset’s estimated salvage value ) / the asset’s useful life
Imagine that a tractor has a historical cost of $110,000, a salvage value of $10,000, and a useful life of 10 years, the equation for calculating straight-line depreciation would look like this:
$110,000-$10,000/ 10 = $10,000
So, the tractor would depreciate by $10,000 every year that the business owner owns it until it reaches the salvage value of $10,000 after ten years. This means that for the first ten years that the person owned the tractor, they would be able to deduct $10,000 in business expenses from their tax returns due to depreciation on the tractor. This is a very significant deduction, and it could potentially save the business owner a lot of money in owed taxes.
Do Business Owners Have to Calculate Depreciation Themselves?
No, business owners do not have to calculate depreciation expenses themselves. They can hire an accountant or a tax specialist to do this for them. Many business owners prefer to have a specialist do it for them because they either find it too stressful or do not want to make any mistakes.
What Happens if You Make a Mistake Calculating Depreciation?
If you decide to calculate depreciation yourself and make a mistake in the process, you could face an audit and even potential financial penalties. This is especially true if you try to calculate depreciation expenses for assets that you are not allowed to calculate depreciation for, such as land or investments like stocks and bonds.
Do You Have to Calculate Deprecation?
No, you do not have to calculate depreciation expenses when you are doing your tax returns. However, if you don’t, you will not be able to deduct depreciation expenses from your taxes. So, if you would like to save money and reduce the amount of taxes that you are obligated to pay the government, then you should strongly consider calculating depreciation and factoring in this deduction into your taxes.
Do All Small Business Owners Calculate Depreciation?
No, not all small business owners calculate depreciation expenses. There are a number of reasons for this. For example, some are too lazy, others don’t know how to do it, and some people don’t even realize that they should be doing it. However, the small business owners who do calculate depreciation expenses for qualifying assets can get a competitive advantage over those who do not.
The Bottom Line
If you are a small business owner, you should consider calculating depreciation expenses for tax purposes. There could literally be tens of thousands of dollars in savings that you are entitled to that you didn’t even know were there. Many small business owners are shocked to discover just how much money they can save by calculating depreciation.
If you do not feel comfortable calculating depreciation yourself, you can hire tax professionals or accountants to do it for you. This will dramatically improve the odds of your depreciation expenses being calculated correctly.