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Understanding Depreciation and Expenses

Understanding Depreciation and Expenses

Depreciation is negative. It is like something losing value. In the tax world, however, depreciation can translate to considerable tax savings. 

Depreciation means deducting the entire cost of an asset you got for business purposes. You will, however, not remove all the real value in a single year. Depreciation of an asset involves writing off parts of the asset over the year. 

The excellent year of the asset determines how long you can depreciate an asset. For tax purposes, there are different categories for various assets, all with their incredible year. In short, the number of years you expect that the asset will be useful determines the method of depreciation. 

Based on the IRS's estimation, for instance, a computer should be depreciated over five years. However, if you are confident that the PC will be useless after three years, you can use a short period for depreciation.

What is an Asset?

The asset is any possession that has value, and the value can be monetized. According to the IRS, the asset can also be categorized as properties that can either be tangible or intangible.

A tangible asset is present, and you can see and touch it. Computer, company vehicles, and office buildings all fall in this category.

Intangible assets, on the other, cannot be touched. They can, however, be exchanged via buying and selling. Intellectual property, patent, or copyright are perfect examples. 

Both categories of an asset can enjoy depreciation. With intangible assets, the depreciation act is known as amortization.


Depreciation Expense 

As you use an asset over the years, the value reduces. Depreciation expense is the part of a fixed asset that has been reduced over the years. The amount is categorized as an expense. The idea is to reduce the value of the fixed asset as you use them over the years. 

This expense is non-cash, meaning that there is no cash flow with it. 

For an entry made to the depreciation expense account, the offsetting credit will go to the accumulated depreciation account. This is a contra asset account that checkmates the fixed asset account. In the depreciation expense account, the balance increases in the asset's fiscal year. This balance is expelled during the closing of the business year. For the coming fiscal year, this account will help store depreciation charges.

This concept also applies to an intangible asset. Here, the associated expense account is called amortization expense.

Forms of Depreciation 

While we have various ways to depreciate assets for your financial statements, the IRS allows a single method. With this method, you can apply depreciation on your tax return. This explains why many small businesses use a technique for their book and something else for their taxes. Others might believe that they are better off using the same depreciation approach for their books.

Here are a few options you can use for book and tax

Straight Line Depreciation

This is the most common way to depreciate a fixed asset. It is a simple approach that divides the value equally over the useful life of the asset. 

This approach is for small businesses that use simple accounting systems. This applies to people or businesses without an accountant or tax advisor to take care of everything related to tax for them. 

How to calculate straight line depreciation: (asset cost – salvage value) / useful life

With this, you can estimate how much depreciation you are allowed to deduct as each year passes. The following example sheds light on it.

Your business buys a truck for $300,000. The salvage value is $1000, and the car has a useful life of 20 years. We will estimate depreciation over the 20 years' interval.

Using the formula: (asset cost – salvage value) / useful life

(300,000 – 1,000) / 20 = $14,950

The implication of this is that you will write off $14,950 every year from the value of the truck for 20 years.



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