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Understanding Depreciation

QUICK SUMMARY

Depreciation isn’t just about lowering your tax bill. It’s also a tool to help you achieve a clearer picture of your long-term expenses—and calculate your business’ true net income. You can use depreciation to help balance your books and plan how much of your revenues you should set aside for replacing machinery, technology, and other assets that will lose their value over time.

Depreciation Defined

In its web article “A Brief Overview of Depreciation,” the IRS defines depreciation as “an annual allowance for the wear and tear, deterioration, or obsolescence” of property. In less technical language, it’s the process of calculating and then spreading out the cost of a business asset over its useful life.

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What Can and Cannot Be Depreciated

Usually depreciation is only applicable to business property whose value will lessen over time. If you hold assets for investment purposes, the point is to have them appreciate—not depreciate. Property you own for personal use also cannot be depreciated; the same goes for any inventory held by your business.

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Straight-Line Depreciation

Straight-line depreciation is the simplest method for calculating depreciation over time. Under this method, the same amount of depreciation is deducted from the value of an asset for every year of its useful life. The “straight line” is literal: If you were to graph the value of your asset over time, it would appear as a straight line from the initial cost to the point where it has reached salvage value.

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Reducing-Balance Method

This approach, also known as the declining-balance method, enables you to accelerate depreciation in the early years of an asset’s “life.” This can be useful for tax purposes—it’s also particularly helpful for types of property impacted by advancements in technology, whose value may diminish fairly rapidly.

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Creating a Depreciation Schedule

To create a depreciation schedule, you’ll need to decide which method of depreciation you want to use for each asset, and determine its expected life as well as its salvage or scrap value, if any.

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