11.1. Basic Concepts

Depreciation is the accounting method for expensing capital purchases over time. There are two reasons that you may want to record depreciation; you are doing bookkeeping for your own personal finances and would like to keep track of your net worth, or you are doing bookkeeping for a small busines and need to produce a financial statement from which you will prepare your tax return.

The method of recording depreciation is the same in either case. but the end goal is different. This section will discuss the differences between the two. But first, some terminology.

11.1.1. Personal Finances

Depreciation is used in personal finances to periodically lower an asset’s value to give you an accurate estimation of your current net worth. For example, if you owned a car you could keep track of its current value by recording depreciation every year. To accomplish this, you record the original purchase as an asset, and then record a depreciation expense each year (See Section 11.4, “Example” for an example). This would result in the net book value being approximately equal to the fair market value of the asset at the end of the year.

Depreciation for personal finance has no tax implications, it is simple used to help you estimate your net worth. Because of this, there are no rules for how you estimate depreciation, use your best judgement.

For which assets should you estimate depreciation? Since the idea of depreciation for personal finances is to give you an estimate of your personal net worth, you need only track depreciation on assets of notable worth that you could potentially sell, such as a car or boat.

11.1.2. Business

As opposed to personal finance where the goal is tracking personal worth, business is concerned with matching the expense of purchasing capital assets with the revenue generated by them. This is done through book depreciation. Businesses must also be concerned with local tax laws covering depreciation of assets. This is known as tax depreciation. The business is free to choose whatever scheme it wants to record book depreciation, but the scheme used for tax depreciation is fixed. More often than not this results in differences between book and tax depreciation, but steps can be taken to reduce these differences.

Now, what purchases should be capitalized? If you expect something that you purchase to help you earn income for more than just the current year, then it should be capitalized. This includes things like land, buildings, equipment, automobiles, and computers - as long as they are used for business purposes. It does not include items that would be considered inventory. So if you made a purchase with the intent to resell the item, it should not be capitalized.

In addition to the purchase of the asset itself, any costs associated with getting the asset into a condition so that you can use it should be capitalized. For example, if you buy a piece of equipment and it needs to be shipped from out of town, and then some electrical work needs to be done so you can plug the machine in, and some specialized training is needed so you know how to use the machine, all these costs would be included in the cost of the equipment.

You also need to know the estimated salvage value of the asset. Generally, this is assumed to be zero. The idea behind knowing the salvage value is that the asset will be depreciated untill the net book value (cost less depreciation) equals the salvage value. Then, when the asset is written off, you will not have a gain or loss resulting from the disposal of the asset.

The last step is to determine the method of depreciation that you want to use. This will be discussed on the next few pages.


Warning: Be aware that different countries can have substantially different tax policies for depreciation; all that this document can really provide is some of the underlying ideas to help you apply your favorite tax/depreciation policies.