Depreciation and Your Business: The Importance of Correct Calculation

Depreciation

Sure, you might have an accountant who calculates depreciation for you. Maybe you don’t, and you have a good friend or even a bookkeeper who can calculate depreciation. However, a lot of startups and newer businesses don’t have the luxury of hiring an accountant, they need to do it for themselves. It’s important you calculate it properly, if you don’t you won’t get the right deductions and it’ll cost you money in the long run.

What Is Depreciation

Basically, depreciation is a way to account for the depreciation (reduction) of the value of an asset over time. Depreciation will usually apply to owned assets and leased assets. Think of a car. If you buy a car new, it immediately loses money when you drive it out of the showroom. That’s depreciation. They also lose money over time. Again, imagine you owned a car show room. Each year the cars you don’t sell depreciate. You need to account for this because essentially your asset worth is lessening. 

Different Types Of Depreciation Calculation

You can account for depreciation differently. There are four standard kinds of depreciation in US GAAP. If you live elsewhere than the USA, there might be other methodologies. If you’re going to be accounting for depreciation you need to pick one which matches your business.

They are:

Straight-line depreciation

The simplest and most common method of depreciation is straight-line depreciation, where the total depreciation expense is simply divided evenly by the number of months in the asset’s useful life. The inputs required to calculate depreciation expense are: the cost of the asset, the salvage value, and the useful life of the asset. Most businesses will use this method, but there are advantages to using other methods depending on the business in question. 

Double Declining Balance Method

Not used as widely as straight-line depreciation, the double declining balance method doesn’t recognize depreciation over the whole life of the asset. Instead, it looks at asset productivity and recognizes that assets are usually more productive when they are newer, with this waning in later years. You can take machinery for example. The older it gets, the less effective it might be. To calculate depreciation using double declining, the rate of depreciation is calculated and multiplied by the book value each year.

Sum Of The Years’ Digits Depreciation Method

This method works by calculating adding up the years in the useful life of the asset and then using the resulting sum to calculate a percentage of the remaining years of the asset. It’s very similar to double declining in that it uses a higher depreciation expense at the beginning of an assets life, but less in later years.

Units Of Production Depreciation Method

This is calculated based on the units the asset produced over the period. Think about line machinery that puts out components or products. To get the calculation right your business will need to estimate your units of production the asset will create/output over the whole lifetime. It’s hard to do if you’re new to the business, but usually the manufacturer will have estimates. You arrive at the depreciation amount per unit by simply dividing the asset cost, minus salvage value, over the total expected units the asset should produce. You can see how niche businesses would use this method.

Those are the main methods of depreciation calculation.

Start As You Mean To Go On

It can be tough finding the right method, but it’s worth thinking it through. You want to start right. For example, if you choose straight-line depreciation to calculate your leased assets you should keep this method year in and out. If you don’t, you can end up confusing yourself because you’ll need to move from one calculation method to another which can be painful. By doing the right research and working out which method is right for the assets your business holds, you’ll make life a lot easier for yourself. 

What The Correct Calculation Gets You

The correct calculation allows you to properly value your business. It also helps with cash flow, and it helps you come to the right deductions on your tax returns. Being compliant with depreciation and following an established method also shows due diligence and can lead to less of a chance for audits and inspections.

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