Accountants use depreciation as a way to allocate the costs of a fixed asset over the period in which the asset is useable to the business. The bookkeeper records the full transaction when the asset is bought, but the value of the asset is gradually reduced by subtracting a portion of that value as a depreciation expense each year.
One key reason to write off assets is to lower your tax bill, so the IRS gets involved in depreciation, too. As a business owner, you can’t write off the cost of all major purchases in one year. Instead the IRS has strict rules about how you can write off assets as tax-deductible expenses.
Businesses don’t depreciate all assets. Low-cost items or items that aren’t expected to last more than one year are recorded in expense accounts rather than asset accounts. For example, office supplies are expense items and not depreciated, but that office copier, which you’ll use for more than one year, is recorded in the books as a fixed asset and depreciated each year.
Lifespan isn’t the deciding factor for depreciation. Some assets that last many years are never depreciated. Consider the following points regarding asset depreciation:
You can always make use of land, so its value never depreciates.
You can’t depreciate property that you lease or rent, but if you make improvements to leased property, you can depreciate the cost of those improvements. To do so, you write off the lease as an expense item and depreciate the lease improvements over their estimated useful life.
You can’t depreciate items that you use outside your business, such as your personal car or home computer, but if you use these assets for both personal needs and business needs, you can depreciate a portion of them based on a percentage of time or other measurement that proves how much you use the car or computer for business.
For example, if you drive your car a total of 12,000 miles in a year and have records showing that 6,000 of those miles were for business purposes, you can depreciate 50 percent of the cost of the car. That percentage is allocated over the anticipated useful life of the car.
You may be able to depreciate a portion of your home’s cost as part of your business expenses. The amount you can depreciate is based on the portion of your home used for business.
Depreciation expenses don’t involve the exchange of cash; they’re solely done for accounting purposes. Most companies enter depreciation expenses into the books once a year just before preparing their annual reports, but others calculate depreciation expenses monthly or quarterly.