There are various forms of depreciation used in the small business world. In general, depreciation is not required but it is advisable. So a small business owner should understand depreciation and the various forms of how to calculate the deduction. Once you understand the reasoning behind depreciation you can better comprehend the different methods and forms of this deduction.
There is no law or requirement for a small business operation to use depreciation. In reality it is nothing more than a paper deduction. You don’t even have to use depreciation for tax accounting. The Internal Revenue Service isn’t going to come after you just because you didn’t take a legal deduction.
What is Depreciation?
So what is depreciation? It is a principle used in accounting to match revenues with the associated costs to produce that revenue. Often the business operation has to purchase some large piece of equipment to make, store or deliver the asset to the customer. This asset will be used many times over in future sales. Depreciation is a calculation of small percentage of the original price as an expense in the current accounting cycle matching costs to the revenue generated in the accounting period.
If you want more information about depreciation, please see Depreciation is Weird Accounting.
Depreciation is grouped into three different forms for use in calculating the deduction. Within each form are methods that can provide the best matching principle depending on your business. The three forms of depreciation are time based, utilization rate and tax. The following sections explain each of the different forms of depreciation.
Forms of Depreciation
This is the most common form of depreciation. This form divides the cost of the asset over a set time period. Because of the simplicity involved and the accounting entry format, it is easily understood by most individuals. The following is an example:
Vehicles are one of the most common assets purchased by all businesses. Most businesses use a period of five years to depreciate the asset. So if each accounting cycle is one month, then 1/60th of the original cost is taken as a depreciation expense on the profit and loss statement.
The following table identifies common assets purchased and the most commonly used time based depreciation cycles:
Computers 3 years
Vehicles/Small Trucks 5 years
Office Furniture/Decorations 7 years
Production Based Equipment 7 years
Field Equipment 3 to 7 years
Animals 12 years
Landscaping 15 years
Parking Lot & Exterior Lighting 19 years
Commercial Buildings 39 years
Residential Rental Property 27.5 years
There is no hard fast rule, just guidance based on industry standards. Publicly traded companies must follow the guidelines promulgated by Security and Exchange Commission and the American Institute of Certified Public Accountants. As a small business owner, you may select whichever time cycle you believe best matches your revenues to the cost of the associated fixed asset used to generate that revenue.
This is not a commonly used form of depreciation for the small business world, but many manufacturing and transportation based operations use this form of depreciation to better match costs to revenue generated. It is also widely accepted in seasonal based businesses as the utility of the asset is greater during that time of the year over the other lower usage periods.
It basically spreads the cost of the asset over its expected production life. A highway tractor rig is a good example. The manufacturer of the rig states that the life expectancy of the rig is approximately zzz,zzz miles with regular maintenance. Therefore, the cost of the truck is divided by the expected number of miles and you get a depreciation rate per mile driven with the tractor (tractor, rig, truck are commonly used terms in the trucking industry). The following is a list of assets and the production factor for division that are commonly associated with utilization rate form of depreciation:
Oil Production Equipment Barrels Pumped
Manufacturing Widgets Produced
Shipping (Sea-Going Vessels) Voyages
Planes Miles Flown
Energy Plants Kilowatts Produced
Waste Water Treatment Plants Gallons Processed
Notice an underlying thread to these assets? They are expensive and highly complex pieces of equipment. The engineering work involved in their design and construction allows for the manufacturer to provide a high level of confidence in their respective production capacity. Therefore, the purchaser can rely on this information to better match the revenues produced against the associated cost. This method is uncommon in the small business world due to the complexity involved along with the measurement function.
This form of taxation is used to report the deduction for tax purposes. The Internal Revenue Service uses several different methods to calculate the deduction depending on the nature of your industry and business.
In general, it is advisable for the small business owner to use this form of depreciation in calculating the deduction for each accounting cycle. The reasoning is straight forward; it reduces the need to calculate the deduction twice. Since you have to use this form in filing the tax return, why spend the energy and resources to calculate the book amount via one of the other forms above.
In general, tax depreciation is accelerated and generates a higher cost for the expense (reduces your tax obligation in the earlier years of use) against the revenues generated. Therefore, it is a poor tool for matching purposes because the accountant uses a misleading deduction against the revenue and thus the profit or loss on the financial statement is misleading.
As your business grows and prospers, you may decide to use the other forms of depreciation and use tax depreciation for the annual IRS filing. By using some other form of depreciation you have the advantage of better matching of costs to the revenues earned.
Remember why we have accounting. It is designed to measure economic activity in a meaningful way. If you decide to use forms of depreciation that will produce misleading outcomes, you may make poor decisions based on that information as the owner of the business. As long as you understand these forms of depreciation and the outcomes they produce you can make the best decisions as it relates to the business aspect of your operation. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my services as an accountant/consultant; click on ‘My Services‘ in the footer of this article.