Why do I have to depreciate an asset?

Why do I have to depreciate an asset?

Why do I have to depreciate an asset?

There are two reasons. One is for tax purposes and the other is because fixed assets have a long life.

Depreciation is pretty important area to understand for most businesses. It will impact your profit and so affect the amount of income tax you have to pay. It will also have an impact on the value of your business when it comes time to sell.

What is depreciation?

Depreciation is best thought of as using up the value of an asset over time.

If you think of a brand new laptop, it’s not going to be worthless after 12 months. It’s more likely that it will last for four or five years, if you take good care of it. It’s also going to help you generate income over a number of years.

Because the asset has a life longer than one accounting period (normally 12 months), we “capitalise” the asset. That’s a fancy word to say that the asset is going to be recorded in the Balance Sheet, rather than the Profit and Loss account.

That’s an important distinction. If the asset was recorded in the Profit and Loss account, you would be able to deduct 100% of the cost of the asset in the year you bought it. By depreciating it, you claim some of that cost each year until the book value is zero.

What assets get depreciated?

All sorts of assets get depreciated. They include tools, machines, computer equipment, plant, motor vehicles, websites and furniture. The assets don’t have to be owned by the business. Sometimes they are leased or purchased using a hire purchase agreement.

In New Zealand, land is not depreciated and most buildings don’t qualify.

Do I have to use depreciation?

The short answer is yes. In New Zealand, any asset over $500 + GST in value must be depreciated. Those rules are set by Inland Revenue. They also determine what rates can be used depending on the type of asset you are depreciating.

You can see more about the various rates by clicking on the link here.

What are the main methods of depreciation?

The most common types of depreciation are “straight-line” and “diminishing value”.

Straight-line depreciation

Straight-line depreciation is perhaps the easiest one to remember.

Imagine you bought an asset for $1,000 and its useful life was 5 years. You might chose to depreciate it at 20%, or $200, per year. Every year, you deduct $200 in depreciation against your income. This calculation goes in the Profit and Loss account.

By the end of year five, the asset would no longer have any value in the Balance Sheet. That’s called straight-line depreciation. Using this method, you have the same value for depreciation every year.

Diminishing Value Depreciation

Under diminishing value depreciation, the asset loses more of its value in the first few years and slows down as the asset gets older. The percentage we use for diminishing value depreciation is normally higher.

Using our example of an asset worth $1,000, and using a diminishing value percentage of 30%., the first year’s depreciation would be $300. That would give a “book value” of $700 after year one.

In year two, we again calculate 30%, this time using the book value ($700). That gives us $210 depreciation in year two. The closing book value in year two would then be $490.

And so on.

Does it matter when I buy an asset?

Yes it does. For most New Zealand businesses, the income year runs from 1 April through to 31 March.

If you buy an asset in March, you’d only be entitled to 1/12th of the depreciation for the year as there would be only one month left in the income year. We call this a “pro-rata” calculation.

If you bought the asset in April, you’d get 100% of the depreciation for the whole income year. So if you want to maximise your deductions for the year, buy your assets as close as possible after 1 April.

What about GST?

If you are registered for GST, fixed assets that will be depreciated are recorded at their GST exclusive price.

If you aren’t GST registered, you can depreciate fixed assets based on their GST-inclusive price.

Angus is the CEO and founder of Generate Accounting.