Depreciation happens to be something that a lot of small business owners tend to either ignore or have misconceptions about, as it usually only applies to fixed assets and only those above a certain threshold. So we’ve decided to explain what depreciation is in detail.
To begin with, Depreciation is an expense for Fixed Assets. When you purchase an asset meant to be used for a longer period, they are given a useful life that depicts how long they are relevant to the business before they are no longer of value. The only exception happens to be the one asset that never loses its value—Land.
Whether it is from wear or tear or technology going obsolete, just about every piece of equipment, machinery, and even buildings will gradually have their value decreased. That loss is recorded as an expense over the course of their useful life as deprecation. To determine this, three factors need to be defined: the initial cost, the expected useful life, and the estimated scrap value.
The Initial Cost is straightforward. It is the purchasing price of the asset along with all of the assorted costs used to obtain it and prepare it for usage. For example, if you purchase a piece of machinery need for the sake of producing goods that you would sell, you would also add in the sales taxes, installation fees, and assembly related to it. These would be recorded as a whole to the value of the asset.
The Useful Life is a little more complex. You see, this is the estimated length of time that the asset is expected to be used in operation for the business. This varies depending not only on the piece of machinery in question but also on additional factors that vary from industry to industry. The IRS has a guideline for some common useful lifespans, such as Vehicles having a flat 5 years of useful life, but some businesses have their own.
The Scrap Value is the expected value of the asset once it reaches the end of its useful life. This amount is an estimate that is determined right as the asset is put into service and serves as the baseline for what the expected worth of it will be after the end of its useful life.
Once these three values are determined, you can obtain the depreciable cost by subtracting the initial cost from the scrap value and then dividing the total by the useful life. For example, a vehicle that has an initial cost of $30,000 will be expected to have a residual value of $12,000 after 5 years, so the depreciable cost will be $18,000 and the annual depreciation will be $3,600.
After you have the annual depreciation cost, you will need to record it into the books annually so that the book value of your fixed asset is properly recorded. To do this, you will debit the Depreciation Expense account and credit the Accumulated Depreciation account.
Dec 31st: Depreciation Expense $3,600
Accumulated Depreciation—Vehicle $3,600
There are different methods than the one used here, such as depreciating the value on a monthly basis, but this is among the simplest and easiest for small business owners to use. The important thing to remember is that the accumulated depreciation should never exceed the original cost of the asset. Once it hits the point where they are even, the asset itself will no longer have any value to the business even if the physical asset exists or still operates.
And that about sums up depreciation.
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