Although depreciation may seem like a negative term, it can actually be very beneficial to your business if you understand how to apply it and leverage it to the maximum. The depreciation value affects your company’s balance sheets and can also affect the net income. Knowing the basics of the term depreciation and having some knowledge as to how you can use it smartly will actually help you to save on your taxes. So, to see how depreciation works let us go through some basics of depreciation and understand what this term actually means and see how different types of depreciation are calculated.
What is Depreciation?
Depreciation is the deduction in the price of a tangible asset which reduces the asset’s monetary value due to a variety of reasons like wear and tear that is caused by a prolonged use of the asset. This can be used as an accounting method which helps you to allocate the portion of the asset’s cost over its useful life which will be displayed on the profit and loss statements of the particular financial year.
However, instead of doing it all in one financial year you can write off parts of over time and plan how much money is written off by depreciating the assets every year. This way you can gain a certain control over your financial management and will help you to plan your finances more efficiently.
When it comes to depreciating an asset you need to consider a few things; one of those is the useful life of the asset. The number of years over which you can depreciate something depends upon its useful life period. For example, computer equipment might have a useful lifespan of five years. Different assets are divided into different classes, each having its own useful life; this is done for tax depreciation. If a different method is used for the financial depreciation by your business, you can decide its useful life by how long you expect to use that particular asset in your business.
In simple terms if you know that a certain asset that you bought for your business will be of no use in a couple of years even though the years of depreciation required are more, you can depreciate that asset early. For example, the ideal years of depreciation for computer equipment are five years. However, if you know that the equipment will be of no use to you in a couple of years, you can depreciate it early.
Any tangible assets like vehicles, real estate, computers, business equipment, office furniture and anything that you have bought for your business to help your business to produce income can be depreciated. If your business makes money from a rental property, you can even depreciate the rental property. While doing so you have to keep in mind that you can depreciate the value of an apartment or a building and not the value of the land on which the building stands. If you make upgrades in the property before renting it out you can add them to the depreciation as well on a condition that they are useful and can last for more than a year.
What is a Depreciation base? What are the methods used to calculate the Depreciation Base?
Depreciation base is the base value on which the percentage of depreciation is applied. To calculate the depreciation, the depreciation base first needs to be calculated. The common formula used for calculating the depreciation base is as follows:
Depreciation base = (Cost of Asset) - (Salvage or residual value at the end of its useful life)
Some methods that are commonly used for calculating the depreciation base are straight line method, written down balance or reducing balance or diminishing balance method, annuity method and sum of years digits method. To understand how the depreciation base is calculated using these methods, let us go through them one by one.
Straight line method The straight line method is sort of an easy method for calculating depreciation. In this method, a fixed percentage is applied to the depreciation base which is calculated and the amount of depreciation will remain the same for the asset up to the end of its useful life. This percentage that is applied to the depreciation base is obtained by dividing the depreciation base of the asset over its useful life years.
Written down balance or reducing balance or diminishing balance In this method a fixed rate of depreciation is applied not to the cost of the asset but to the reducing or written off value of the asset which is held in the account books at the start of a financial year. In the written down balance or reducing balance or diminishing balance method, the depreciation per year and the carrying value of an asset is higher in the initial years and reduces over time.
Annuity method The annuity method does not consider the useful life of an asset in terms of years but considers it in terms of production capacity. To put it in simple terms, you can say that the annuity method used in the calculation of depreciation is not time based. For example, when calculating the depreciation for a production machine, the total cost of that machine will be divided by the total units manufactured by that machine which represents its production capacity. The value that you get by this calculation is the depreciation value of that machine per unit. This value is then multiplied by the number of units manufactured in a financial year to get the total depreciation value for that year.
Sum of years digits method The sum of years digits method involves accelerated depreciation, in which the assets useful life years are added to calculate the depreciation rate. For example, if the useful life years of an asset is 7 years, the sum of digits will be 1 + 2 + 3 + 4 + 5 + 6 + 7 = 28. The depreciation of that asset over a specific period of time will then be calculated based on the remaining useful life years of the asset. Which means the depreciation for the first year will be 7/28, for the second year will be 6/28 and so on.
