Most businesses have assets (things of value) and the value of these assets changes over time. These changes affect the value of your business and your business taxes.
How Depreciation Works
The change in the value of business assets is depreciation. This term means two things:
- A way to spread the cost of a business asset over its useful life, and
- The gradual loss in the value of an asset.
The value of business assets is shown on your business balance sheet, a financial report that shows assets on one side, with liabilities (amounts owed by the business) and the business owner's equity (the difference between assets and liabilities, or the amount the owner owns) on the other side. Like this:
|Simple Business Balance Sheet|
|Total Assets||$100,000||Total Liabilities||$50,000|
|Total Owner's Equity||$50,000|
|Total Assets||$100,000||Total Liabilities and Owner's Equity||$100,000|
Accumulated Depreciation on Long-Term Assets
Some assets are short-term, used up within a year (like office supplies). Long-term assets are used over several years, so the cost is spread out over those years. Short-term assets are put on your business balance sheet, but they aren't depreciated.
Long-term assets are depreciated. Examples are buildings, machinery, equipment, furniture and fixtures, and vehicles. The IRS calls these capital assets: tangible and generally illiquid (not easily turned into cash) property used by a business to generate profit. The usefulness of capital assets is expected to be greater than a year.
Accumulated depreciation is the total decrease in the value of an asset on the balance sheet of a business, over time. The cost for each year you own the asset becomes a business expense for that year. This expense is tax-deductible, so it reduces your business taxable income for the year.
Two more terms that relate to long-term assets:
Residual value. Most capital assets (except land) have a residual value, sometimes called "scrap value" or "salvage value." This value is what the asset is worth at the end of its useful life and what it could be sold for.
Book value. The value of the asset on your business balance sheet at any one time is called its book value - the original cost minus accumulated depreciation. Book value may (but not necessarily) be related to the price of the asset if you sell it, depending on whether the asset has residual value.
Depreciation is a tax term. You must calculate depreciation on capital assets every year, so you can include this depreciation cost on your business tax return.
Accumulated depreciation is an accounting term. You take the depreciation for all capital assets for the current year and add to the accumulated depreciation on those assets for previous years to get the current year's accumulated depreciation on your business balance sheet.
Business Assets on a Balance Sheet
Look at the balance sheet of a business and at the assets on the left side. We'll focus on the long-term assets:
|Land and Buildings||$200,000|
|Furniture and Fixtures||$ 26,000|
|Leasehold Improvements||$ 74,000|
|Less: Accumulated Depreciation||$ 20,000|
Land and Buildings are listed first. Land is never depreciated. Since land and buildings are bought together, you must separate the cost of the land and the cost of the building to figure depreciation on the building.
All of the specific items being depreciated in the other categories – furniture and fixtures, leasehold improvements, and vehicles – have their own account, which shows the initial cost of the item and the amount of depreciation taken each year, with the total amount of depreciation shown as accumulated depreciation.
Depreciation Expense and Accumulated Depreciation
Let's say you have a car used in your business that has a value of $25,000. It depreciates over 10 years, so you can take $2,500 in depreciation expense each year.
|Year||Initial Cost||Depreciation||Accumulated Depreciation||Book Value|
Accumulated Depreciation on a Balance Sheet
The values of all assets of each type are considered together on the balance sheet, rather than showing the value of individual assets. That car is in there somewhere.
Here's the tricky part. The car doesn't really decrease in value - until it's sold. So the asset shows up in two different accounts: (1) the asset's depreciated cost, and (2) accumulated depreciation. The total of the two is the original value (cost) of the asset. The difference between the two is the book value of that asset.
An Example of Accumulated Depreciation on a Balance Sheet
On the balance sheet of the company on December 31, 2019:
- Cost of Equipment $239,000
- Less Accumulated Depreciation $100,000
- Book Value of Equipment $139,000.
Accumulated Depreciation and Your Business Taxes
You won't see "Accumulated Depreciation" on a business tax form, but depreciation itself is included, as noted above, as an expense on the business profit and loss report. The good news is that depreciation is a "non-cash" expense. You can count it as an expense to reduce the income tax your business must pay, but you didn't have to spend any money to get this deduction.
What shows up on your business tax form is the amount of depreciation expense that was taken for the year, including all types of depreciation on all business property. For example, on a Schedule C for a sole proprietor business, Line 13 under Expenses says, "Depreciation and Section 179 deductions...." That's where you will see the total of all depreciation taken during the year.
You must complete IRS Form 4562 Depreciation and Amortization for property in some circumstances:
- If you are taking a Section 179 deduction for the current year or a Section 179 carryover deduction from a prior year
- If you placed the property in service (bought and started using it) during the current year
- If you are claiming depreciation expense on a vehicle or on listed property, regardless of when it was placed in service.
Business vs. Personal Use. If you use an asset, like a car, for both business and personal travel, you can't depreciate the entire value of the car, but only the percentage of use that's for business. For example, if you use your car 60% of the time for business and 40% for personal, you can only depreciate 60%.
You can also accelerate depreciation legally, getting more of a tax benefit in the first year you own the property and put it into service (begin using it). The extra amounts of depreciation include bonus depreciation and Section 179 deductions. These amounts change each year, so check with your tax preparer.
Accumulated Depreciation and the Sale of a Business Asset
When you sell an asset, like the vehicle machine discussed above, the book value of the asset and the accumulated depreciation for that asset are removed from the balance sheet. Since the original cost of the asset is still shown on the balance sheet, it's easy to see what profit or loss has been recognized from the sale of that asset.