What it means
For an asset to be depreciable it normally has to meet several tests at once: the business must own it, it must be used in the business, it must have a useful life longer than a year, and that life must be determinable. An asset that fails any of these, such as a short-life consumable or a piece of art expected to last indefinitely, is treated differently.
Land is the classic exclusion and the one that trips people up on a property purchase. When a building and its land are bought together the price has to be split, because only the building portion can be depreciated over time.
Depreciation exists to match cost with benefit rather than to track market value. A delivery van bought for $40,000 earns income across several years, so charging the whole cost against the first year's profit would badly misstate how the business actually performed.
Tax rules and accounting rules often diverge here, which is why many businesses run two sets of depreciation figures. The accounts use a useful life the directors consider realistic, while the tax computation follows a prescribed schedule of rates and asset classes set by the tax authority.
Improvements complicate the picture in a useful way. Money spent restoring an asset to working order is usually an expense, while money spent extending its life or increasing its capacity is capitalised and becomes depreciable property in its own right.
In practice
Real-world examples.
Example
A printing firm buys a $220,000 press with an expected ten year life and a $20,000 resale value. The press is depreciable property, and the firm charges ($220,000 - $20,000) / 10 = $20,000 a year against profit for a decade.
Example
A restaurant spends $85,000 fitting out a leased unit with a kitchen, bar and seating. Although it does not own the building, the fit-out itself is depreciable property, written off over the shorter of its useful life and the remaining lease term.
Example
A haulage company buys land and a depot for $1,200,000. The accountant allocates $400,000 to land and $800,000 to the depot building, so only $800,000 enters the depreciation schedule and the land stays at cost indefinitely.
Formula
Calculation
Annual straight line depreciation = (cost of depreciable asset - salvage value) / useful life in years.
A dental practice buys a small commercial building for $650,000. A valuation splits the price into $150,000 for the land and $500,000 for the building itself. Only the $500,000 building is depreciable property, since land is not depreciated.
The practice estimates a 40 year useful life and no salvage value at the end of it.
Annual depreciation = ($500,000 - $0) / 40 = $12,500 per year.
After eight years, accumulated depreciation is 8 x $12,500 = $100,000, so the building is carried at $500,000 - $100,000 = $400,000. Adding back the land, the property sits on the balance sheet at $400,000 + $150,000 = $550,000, even though its market value may be higher or lower.Case study
Seen in the real world.
The following is a fictional, illustrative example. Wexford Cold Storage, an invented business, bought a warehouse site for $2,000,000 and put the entire amount into its depreciation schedule over 25 years, charging $80,000 a year to profit.
At the first audit the accountant pointed out that roughly $600,000 of the purchase price related to land, which is not depreciable property. The corrected charge was $1,400,000 over 25 years, or $56,000 a year, meaning profit had been understated by $24,000 in each of the two years since purchase.
In this illustrative case the correction cost the company nothing in cash but changed its reported profit, its bank covenant headroom and its tax position, which is why the land split is worth getting right at the point of purchase rather than years later.
Watch out
Common mistakes.
- Depreciating the full purchase price of a property including the land, which overstates the annual charge and understates reported profit.
- Treating every repair as a depreciable improvement, when routine maintenance that simply keeps an asset working should be expensed in the year it is incurred.
- Assuming the depreciation shown in the accounts is also the figure allowed for tax, when most tax systems apply their own rates and asset categories.
Questions
People also ask.
What makes an asset depreciable?
It must be owned by the business, used to produce income, have a useful life of more than one year, and wear out or become obsolete over a period that can be estimated.
Is a leased asset depreciable property?
It depends on the lease, since assets held under leases that transfer the risks and rewards of ownership are usually capitalised and depreciated by the lessee, while short simple rentals are just an expense.
Can I depreciate an asset I use for both business and personal purposes?
Only the business use proportion is depreciable, so a vehicle used 70% for business would have 70% of its depreciation claimed.
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