What Is Depreciation?
The bookkeeping and accounting concept of depreciation is really pretty simple. Asset depreciates. Measuring the loss in value over time of a fixed asset, such as a building or a piece of equipment or a motor vehicle, is known as depreciation. Depreciation is considered an expense and is listed in an income statement under expenses. In addition to vehicles that may be used in your business, you can depreciate office furniture, office equipment, any buildings you own, and machinery you use to manufacture products. Land is not considered an expense, nor can it be depreciated. Land does not wear out like vehicles or equipment do.
To find the annual depreciation cost for your assets, you need to know the initial cost of the assets. You also need to determine how many years you think the assets will retain value for your business. For example, let’s say you purchase a truck for your business. The truck loses value the minute you drive it out of the dealership. The truck is considered an operational asset in running your business. Each year that you own the truck, it loses some value, until the truck finally stops running and has no value to the business.
To accurately create your historical financial statements or your pro forma (projected) financial statements you need to calculate both depreciation and amortization. Hence if you are creating a business plan you need to calculate both depreciation and amortization.
Straight-line depreciation is considered the most common depreciation method. To compute the amount of annual depreciation expense using the straight-line method requires two numbers: the initial cost of the asset and its estimated useful life. For example, you purchase a truck for $50,000 and expect it to be used in your business for 10 years. Using the straight-line method for determining depreciation, you would divide the initial cost of the truck by its useful life.
So, for the first 10 years you own the truck, you would record a depreciation expense of $5,000. Each year you would list the truck as an asset on your balance sheet. But each year, as you expense the $5,000 depreciation, you subtract $5,000 from the value you list the truck for on your balance sheet. For example, after you have owned the truck for five years, you have expensed $5,000 for each of five years, or $25,000 total. Subtracting this from the initial purchase price of the truck, your truck would now be listed with a value of $25,000 on your balance sheet. This is called the “book value.” It will likely either be higher or lower than the actual market value, or the value you could sell the truck for. After 10 years, you will have expensed $5,000 per year for a total of $50,000, the purchase price of the truck. The truck will now have zero value on your balance sheet and is considered “fully depreciated.”
Straight-Line Depreciation Formula
Initial Cost / Useful Life = Depreciation per Year
$50,000 / 10 = $5,000 per year
If you sell the truck, you will have to adjust the actual sales price to the book value by taking a capital gain or loss. For example, if you sell the truck for $2,000 in year 12 when it has zero book value, you will have a capital gain of $2,000, which will be added to your reported income. But because you owned the truck for more than one year, in the U.S. it is considered a long-term capital gain and thus subject to a lower tax rate.
Capital Gain Formula
Initial Cost = $50,000
Depreciation per Year = $5,000
Number of Years to Fully Depreciate = 10 Years
Book Value in Year 12 (also at end of years 10 and 11) = $0
Sale Price in Year 12 = $2,000
Capital Gain in Year 12 (Sale Price) = $2,000 – (Book Value) $0 = $2,000
To encourage investment spending, governments often pass legislation to allow what is called “accelerated depreciation,” which allows businesses to more quickly expense depreciation than they are allowed to under straight-line depreciation. With accelerated depreciation, you are typically allowed to deduct a higher percentage of your depreciation in the first few years.
Sometimes, governments even let small businesses deduct all of their capital expenses up to a small threshold in the first year, particularly when they are trying to ramp up the economy in a small way—since small businesses are the growth job engines of the economy—or because some politicians are trying really hard to win political support from small businesses.
Because these regulations change from time to time and can be tedious to follow, I’d simply forget about them until tax time and let my accountant do the reading of the fine print. The only exception would be if I were in an extremely capital-intensive business and the treatment of deprecation would have a significant impact on my investment decisions.
What Is Amortization?
In the course of doing business, you will likely acquire what are known as “intangible assets.” These assets can contribute to the revenue growth of your business and, as such, can be expensed against these future revenues. An example of an intangible asset is when you buy a patent for an invention.
The formula for calculating the amortization on an intangible asset is similar to the one used for calculating straight-line depreciation: you divide the initial cost of the intangible asset by the estimated useful life of the intangible asset. For example, if it costs $10,000 to acquire a patent and it has an estimated useful life of 10 years, then the amortized amount per year equals $1,000. The amount of amortization accumulated since the asset was acquired appears on the balance sheet as a deduction under the amortized asset.
Initial Cost / Useful Life = Amortization per Year
$10,000 / 10 = $1,000 per Year
For most small businesses, amortization will play a smaller role over time than will depreciation, so I wouldn’t spend a lot of time thinking about it. Basically, it is very similar to depreciation. For a new small business owner, one of the most common ways you run into amortization is if your accountant advises you that the expenses incurred in beginning your business are the type of start-up costs that need to be amortized over time, instead of operating expenses that can be expensed immediately. I know it sounds unfair—why can’t you just expense start-up expenses immediately? Well, governments don’t make a habit of doing things to make life easy for small businesses, so get used to it and move on!
Takeaways You Can Use
- Depreciation is how you measure the loss in value of an asset.
- Depreciation is an accounting figure only; it doesn’t involve a cash outlay.
- Amortization is how you measure the loss in value of an intangible asset’s expense.
For More on Financial Statements and Business Plans
For more on how to create financial statements and projections see my course, Accounting & Financial Statements. This course includes step-by-step instructions, samples and templates for creating historical and pro forma income statements, balance sheets and cash flows.
You may also be interested in my course, How to Create a Business Plan. This course includes step-by-step video instructions, samples and fill-in-the-blank templates for both a one page business plan and a full length business plan.
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