Businesses have a choice of the way they choose to keep track of their accounting. Often the choice to account one way on the books and another way when it comes to doing federal taxes is different. One of the most popular ways is through the process of depreciation accounting.
Depreciation accounting is done by depreciating the value of an asset over the entire length of its determined useful life.
- Depreciation over the useful life of an asset occurs due to normal wear and tear, age, or simply because the asset becomes obsolete.
- Depreciated accounting is used for non-cash assets like machinery and supplies.
- Depreciation accounting is a way to lower the company’s earnings that it reports on its federal income taxes and increases the value of the company’s cash flow.
Example of Depreciation Accounting
To explain depreciation accounting, it is helpful to look at a basic example:
- Let’s pretend that company XYZ purchased a piece of machinery for $500,000 that had a pre-determined useful life of 50 years.
- To find the value that this piece of machinery will depreciate over the span of its useful life according to depreciation accounting, you will divide the amount paid for the piece of machinery by the amount of years of its useful life.
- When you do the math, you find that the depreciated value that should be used is $10,000 a year.
- Therefore, when preparing the accounting sheets and income statements for the year for this particular piece of machinery you would write off the $10,000 amount each year which would decrease the company’s earnings or taxable income.
Depreciation Accounting for Land
Depreciation accounting can also be used for the purchase of a new building or plant. However, the process is a bit different.
- When a company purchases a building on a piece of land, the building can be written off as a depreciable asset despite that fact that it will actually increase in value.
- However, the land that the building or plant sits on cannot be written off as a depreciable asset.
- Therefore, if a company were to purchase a building or plant for the price of $1,000,000 and the land that this building sits on is worth $100,000 of this price, the cost of the depreciable asset would be $1,000,000 minus $100,000 or $900,000.
- The company would then determine the useful life of the building.
- If the useful life of the plant or building was determined to be 50 years then the amount of depreciation for the building each year would be written off on their taxable income as $18,000 per year.
You can see the potential tax savings with depreciation accounting and you can also understand how and why businesses use this to allow them to deduct expenses. Even small business owners can do this with appropriate items. For example, if you work at home and use your computer for work all the time, you may be able to use depreciation accounting to deduct the depreciation of your computer.