Tax season is upon us, and as a result, many people are looking for the best strategies to come out on top. There is only so much you can do, so advice can be limited without speaking to a tax professional. One of the most important things you can do, however, is depreciate your assets. This is advice that you may have been told previously, but have you ever asked why? In this article, we will look at both why depreciating your assets is important, and how to do so.
What does it mean to depreciate your assets?
The literal definition of depreciating is the method by which you allocate the cost of a tangible or physical asset over a long period of time of its useful life. This means you calculate the cost of something over time instead of when you first purchase it. A good example of this is a company that purchases some new heavy machinery. This machine might have a large cost upfront, but there are many other costs to consider other than this initial purchase. Instead of writing everything off all at once, it is spread out over the course of the machinery’s life. This is just one example of a way depreciation is done, but there are a number of other scenarios in which it would be necessary.
Why should you depreciate?
We now understand what depreciation is, but why is it such an important thing? As we mentioned before, businesses are one of the main users of depreciation techniques. Certain assets that are purchased can be essential to a business, but they might be very expensive to write off in the same tax year they’re purchased.
This is why depreciating over time makes more sense in the long run. Some assets have an estimated lifespan, so they tend to be easier to calculate for depreciation purposes. The lifetime of these assets might also change over time depending on the maintenance that is done on it and how well it is taken care of. This uncertainty is what makes depreciating your assets so important. The ability to update things as you go is a helpful tool, especially for assets that have a high initial investment.
What types of depreciation are there?
There isn’t just one way to depreciate your assets. There are actually several methods you can use when it comes to depreciating assets. This section will go over some of the more known examples of depreciation, and why you should use them.
Straight-Line
Straight-line is one of the most common and basic ways of depreciating assets. Straight-line is when you report an equal depreciation amount annually throughout the entire useful life of the asset up until it reaches its salvage value. To calculate it, you must subtract the asset's purchase price from the approximate salvage value, and divide the resulting figure by the asset's estimated useful life.
(Purchase price of asset – salvage value) / estimated useful life.
Double Declining Balance (DDB)
A double declining balance is what is referred to as an accelerated depreciation method. It lets you write off more of an asset's value immediately after purchasing it, and less as time goes on. As such, it is a good method for those that want to recover more of an asset's value early on rather than waiting. The double declining balance is calculated as follows:
DDB = (Net Book Value – Salvage Value) x (2 / Useful Life) x Depreciation Rate
Declining Balance
As their names imply, a declining balance is about half of the rate of a double declining balance. It does essentially the same thing as DDB, but at a slower rate. The formula for declining balance depreciation is:
(Net Book Value – Salvage Value) x (1 / Useful Life) x Depreciation Rate
Sum-of-The-Year’s Digits (SYD)
The last type of depreciation we’ll look at today is the sum-of-the-year’s digits (SYD). Like DDB or declining balance, this is another type of accelerated depreciation method. Businesses often utilize this technique to retrieve a greater part of an asset's value in advance. However, it provides a more extensive allocation than what one would obtain through DDB.
This method is unfortunately a bit trickier to calculate than the others we have learned about thus far. In order to use this depreciation method, you must first calculate the SYD. This is done by adding up the depreciation for each of the years. For example, if you were to depreciate for five years, it would look like 5+4+3+2+1 = 15. You then have to divide each year by this sum to calculate that year’s depreciation percentage (so the first year would be 5/15, which comes out to 33%).
The formula ends up looking like this:
(Remaining lifespan / SYD) x (Asset cost – Salvage value).
When should you depreciate your assets?
As we have learned, depreciating your assets can be done in many different ways. It doesn’t have to be a complicated process, however. The important thing is that you start the process as soon as possible. This way, you’ll be able to accurately record the amount an asset depreciates and rake in any tax benefits it will bring. Because depreciation is deductible as a business expense, you should be sure to do it whenever it is possible.