Depreciation is the accounting method that captures the reduction in value, and accumulated depreciation is the total amount of the depreciated asset at a specific point in time. These changes can affect the value of your business and your taxes.
How Depreciation Works
The change in the value of business assets is depreciation. This term means two things: 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:
Long-Term Assets
Since long-term assets are typically used over many years, they are depreciated as they reduce in value over their useful life. Examples of long-term assets include:
BuildingsMachineryEquipmentFurniture and fixturesVehicles
The Internal Revenue Service (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 one year.
Accumulated Depreciation
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, meaning it reduces your business’s taxable income for the year.
Residual Value and Book Value
When discussing depreciation, two more accounting terms are important in determining the value of a long-term asset. 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 when the company has finished with it. 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.
Business Assets on a Balance Sheet
In the table below is the balance sheet of a business with its assets listed on the left side. We’ll focus on the long-term assets: 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. 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. This depreciation expense is taken along with other expenses on the business profit and loss report. As the asset ages, accumulated depreciation increases and the book value of the car decreases. However, 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.
Example of Accumulated Depreciation on a Balance Sheet
Below is the balance sheet of a company on December 31:
Cost of Equipment $239,000Less Accumulated Depreciation $100,000Book 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.
IRS Form Schedule C
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 an IRS Schedule C form for a sole proprietor business, Line 13 under Expenses says, “Depreciation and Section 179 deductions…” and that’s where you’ll see the total of all depreciation taken during the year.
IRS Form 4562
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 yearIf you placed the property in service (bought and started using it) during the current yearIf 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, the book value of the asset and the accumulated depreciation for that asset are both 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. Depreciation helps companies reduce their income taxes because the amount of depreciation can be deducted from income, reducing your total taxable income.
