For purposes of keeping the books for your small company,
depreciation is the method used to distribute the cost of a
fixed asset over its useful life. Depreciation expense is
recognized in each period, in order to match the income
generated by the company with the expenses incurred in order to
produce the revenue, including part of the cost of property,
plant and equipment.
An offset is recorded in accumulated depreciation,
which is an account with a credit balance in the asset section
of the balance sheet. Accumulated depreciation is presented in
the financial statements along with the corresponding assets, to
show the balance in property, plant, and equipment, net of
depreciation. For tax purposes, depreciation is the way you
recover the cost represented by your investment in the asset,
through deductions you can take on your annual federal income
tax return.
Depreciation for financial accounting purposes; that is, the
depreciation you record on your books and report in your
financial statements, can be different from the depreciation you
can claim for tax purposes. Note, only assets can be
depreciated. Not expenses such as our
registered agent service.
Depreciation Methods for Financial Accounting Purposes
Depreciation for financial accounting purposes can be calculated based on production or the passage of time. When it is calculated based on time, depreciation can be straight-line, with equal charges every period, or it can be decreasing, with higher charges at the beginning of the asset's useful life, that decrease over time.
Depreciation Based on Level of Activity or Units of Production
According to this method, the asset is depreciated based on its
use or productivity instead of the passage of time. The useful
life of the asset is defined based on its yield or capacity,
such as the quantity of units it can produce, or the hours it
can work.
In order to use this method, you need to know the capacity of
the asset, such as a machine, during its useful life. This
information could be available in the user's manual or in the
technical specifications for the machine, or you could make an
estimate based on experience with the same or a similar machine.
You also need to keep records of the number of units actually
produced each period, or the number of hours the machine
operates.
The depreciation charge for the period, in the case of units of
production, would be calculated as follows:
Cost of the asset less salvage value = depreciable amount.
Depreciable amount divided by total number of units that the
asset will produce during its useful life = depreciation charge
per unit. Depreciation charge per unit multiplied by the number
of units produced during the period = depreciation charge for
the period.
Straight Line Depreciation
According to the straight-line method, depreciation is
calculated as a function of time and not use. This method is
based on the idea that the wear on the asset and its
obsolescence, and therefore the reduction of its usefulness,
occurs uniformly and progressively during the useful life of the
asset, so equal charges are made to depreciation every period.
This method is widely used in practice due to its simplicity.
In order to calculate straight-line depreciation, you need to
know the book value of the asset, its useful life and its
residual or salvage value. The book value would normally be the
cost of the asset, including all costs to put the asset in the
place and condition in which it can be operated for its intended
purpose. The useful life will depend on the type of asset; for
example, a building could have a useful life of about 50 years,
while a computer could have a useful life of from 3 to 5 years.
The salvage value could be the price at which you could sell the
asset when it is no longer useful in your operation. In many
cases, the salvage value is the scrap value in the case of
machinery that is completely worn out at the end of its useful
life.
Straight-line depreciation is calculated as follows:
Book value of the asset - salvage value / useful life (in years
or months) = depreciation charge per period (year or month).
Decreasing Depreciation
According to decreasing depreciation methods, charges for
depreciation are higher in the earlier years and lower in the
later years. These methods may be more appropriate when the
asset loses more of its capacity for service during the first
part of its useful life. There are different ways to calculate
decreasing depreciation, such as the sum of the years' digits,
and the double declining balance methods.
Sum of the Digits
A decreasing fraction is applied to the depreciable value of the
asset (original cost less salvage value). The denominator of the
fraction is the sum of the digits that represent the years of
life, and this denominator remains constant. The numerator of
the fraction decreases from one year to the next. For example,
for an asset with a useful life of 5 years, the denominator of
the fraction would be 15 (5 + 4 + 3 + 2 + 1 = 15). The first
year, the factor to be applied to calculate the depreciation
would be 5/15, the second year 4/15 and continuing on
successively until in the fifth year it would be 1/15.
According to this method, a percentage is applied to the net
book value of the asset (cost less accumulated depreciation).
The percentage that is applied is double the percentage that
would be applied under the straight-line depreciation method.
Double Decline
For example, a machine that has a cost of $10,000 and a useful
life of 5 years, the depreciation percentage according to the
straight-line method would be 20% (1/5). According to the double
declining balance method, double that rate would be applied, so
at 40% the depreciation charge for the first year would be
$4,000 ($10,000 x 40%). The second year, the same 40% rate is
applied to the net value of $6,000, which is the original cost
of $10,000 less accumulated depreciation of $4,000, resulting in
a depreciation charge of $2,400 ($6,000 x 40%) the second year.
This would continue on successively until the asset if fully
depreciated down o its salvage value.
Depreciation for Taxes
In general, a taxpayer cannot take a deduction for the
entire cost of an asset used in a business in the year the
asset is acquired if the asset has a useful life of over one
year. (An exception to this general rule is the section 179
deduction.) Instead, the cost is recovered through
depreciation deductions over the useful life of the asset.
The U.S. Internal Revenue Service (IRS) establishes
guidelines for determining which assets are subject to
depreciation or amortization, as well as the methods that
must be used to calculate depreciation.
Assets Subject To Tax Depreciation
In order to depreciate or amortize assets for tax purposes,
the assets must satisfy the following tests:
The assets must belong to the taxpayer, although leasehold
improvements can also be depreciated when the improvements
constitute capital assets.
The assets must be used in a business or an activity for the
production of taxable income. It cannot be property that is
used exclusively for personal purposes. If an asset is used
for both business and personal activities, such as a vehicle
or a portion of your home used for business, you can take a
depreciation deduction for the proportional cost of the
asset that corresponds to the percentage of business use.
The assets must have a determinable useful life that is
longer than one year.
It cannot be property specifically excluded according to the
IRS, such as land, goods placed in service and later sold or
disposed of the same year, and certain intangible assets
such as franchises, non-competition agreements, and
goodwill.
How to Determine the Depreciation Deduction
In order to determine the depreciation you can deduct for
tax purposes, you need to know the following:
When the asset was placed in service, which is generally the
date on which the asset was ready and available for use,
regardless of whether it actually started to be used on that
date.
The basis of the asset for tax purposes. The basis can be
cost or some other amount, depending on how you acquired the
asset. For example, an asset that is acquired in a taxable
exchange is normally its fair market value on the date of
the exchange. You can consult chapter 13, Basis of Property,
in IRS Publication 17 (www.irs.gov) for more guidance on how
to determine the basis of assets for tax purposes.
The applicable depreciation method. The majority of assets
are depreciated according to the Modified Accelerated Cost
Recovery System of the IRS. This method applies to assets
placed in service after 1986. But there are certain
situations where you cannot use this method. IRS Publication
946, How to Depreciate Property, indicates the situations
where you must use another method.
The asset life, according to the classes established by the
IRS. In Publication 946, there is a table that shows the
different types of assets and their corresponding classes.
Section 179 Deduction
In some cases, a taxpayer can elect to take a deduction for
all or part of the cost of certain items the first year,
rather than recovering the cost through depreciation. This
special deduction, according to section 179 of the Internal
Revenue Code, applies only to assets acquired for use in a
trade or business. It does not apply to items occupied in
other income-producing activities, such as rentals, which do
not constitute the taxpayer's line of business. For more
information on this deduction, you can consult IRS
Publication 946, as previously indicated.
Additional First-Year Depreciation
For certain qualified items, it may be possible to take a
deduction for additional depreciation the first year. This
additional depreciation is 30% for assets acquired after
September 10, 2001, or 50% for assets acquired after May 5,
2003.
Reconciliation of Depreciation for Book and Tax
Purposes
As can be seen from the foregoing, depreciation for book
purposes can be different from depreciation for tax
purposes. The necessary records and documentation need to be
kept in order to correctly calculate depreciation in both
cases, and these records must be maintained throughout the
life of the assets.
For tax purposes, in addition to being able to take the
corresponding depreciation deductions each year, it will be
necessary to know the amount of accumulated depreciation in
the event you sell or dispose of an asset, in order to
calculate the gain or loss on the sale or disposal, and to
determine any depreciation that may have to be recaptured as
ordinary income for tax purposes.
Recent changes to tax laws for LLCs mean you should seek the
most up to date information. Learn more about
forming an LLC and our
book keeping services.
New Mexico Corporate Services
Thank you for taking the time to read our page. Beyond resource articles, we offer numerous services designed to make opening and running your company easy. We can help you form an LLC in New Mexico and act as your registered agent in New Mexico.
