Understanding the concept of depreciation is an essential aspect of your business. Depreciation will affect your taxes, prices and the overall value of your business. It can also affect any decisions you make regarding your business.
What Is Depreciation?
Depreciation is the percentage of value that a piece of equipment or asset loses each year, usually a percentage of the first year’s cost estimate. For example, you purchased a $20,000 piece of equipment in 2011. After five years, its value goes down to $15,000, depreciating with a $1,000 value per year.
What Is the Purpose of Depreciation in Accounting?
There are several reasons why depreciation is important in your business account and finances.
- Reduce Taxes
The government requires business owners to pay taxes on the value of their assets. By calculating and reporting the percentage of depreciation for each asset, accountants can reduce the amount of taxes owed on the original cost.
- Determine the Value of a Business
Depreciation is used to calculate the value of a business based on the number of assets you own. If you own a $5 million business, but your assets are depreciating at a rate of $200,000 a year, your actual asset value is $4,700,000.
- Calculate Budgeting
In simple terms, depreciation allows your accountant to project the value of your assets and plan for the future of your business. For example, if you expect an asset to depreciate by $250,000 over the next five years, you will need to either pay or plan for the loss of that money.
- Determine Product Prices
If a product loses value over time, you can factor in the estimated depreciation cost before determining the final value. This can be used to calculate the cost of production and the final product price.
What Assets Can Be Depreciated?
There are different types of assets that can be depreciated. Depending on what type they are, their value will also vary.
- Long-term Assets
These are items you plan to own and use in your business for more than one year. Long-term assets include land, buildings, vehicles, equipment and furniture.
- Short-Term Assets
Items that you own for less than one year, including inventory, equipment and supplies.
What Are the Methods of Calculating Depreciation?
You can use different methods to calculate depreciation, including straight-line depreciation and diminishing value depreciation. Whichever way you choose will affect the outcome of the value.
- Straight Line Depreciation
This is the most common method used to calculate depreciation. Straight-line depreciation is calculated by dividing the estimated value of an asset by the number of years it’s expected to last.
Example: $20,000 / 5 years = $4,000 value per year
- Diminishing Value Depreciation
This method uses decreasing percentages to calculate the decline in value. Depreciation varies for each year that your asset will be used.
Example: $20,000 * 10% / 5 years = $4,000 in the first year, $3,600 in the second year, $3,200 in the third year, $2,800 in the fourth year, and $2,400 in the fifth year
When your business purchases new equipment, furniture or vehicles, you will have to pay taxes on the value of the assets. Understanding the purpose of depreciation and how it will affect your business is important for tax planning and your financial future.
If you need an accountant in Gold Coast to help with your business, you can contact us at New Wave Accounting. We offer accounting and bookkeeping services to all businesses, helping you grow. Get in touch with us today for a consultation.