subject: Correct Application of Depreciation Reduces Tax [print this page] Correct Application of Depreciation Reduces Tax
Copyright (c) 2010 Nadine DavisMany entrepreneurs establish and run highly successful businesses without detailed knowledge of accounting practices. Their flair for marketing, providing customer service and subject knowledge about their products are the most important aspect of running a successful business, which is why they generally leave the accounting questions to Accountants.Depreciation, put simply, is the cost of an asset, spread over its useful life. The question of useful life is important in accounting because it is fundamental to a core principle - "matching". It is essential to match the income from the business with the expenses incurred in creating that income within the same time frame. This is held up by the taxation system, which requires a tax payer (including business tax payers) to lodge a return every twelve months.When an asset such as property, a vehicle, computer equipment etc. is purchased, money is immediately outlaid, pre-paying for the use of this asset to generate income, over a much longer period of time than twelve months. Even after some time has passed, you still have possession of that asset. When expenses such as the phone bill, council rates, wages, stationery, etc are paid, that money is used up within twelve months, with nothing to show for it except a good reputation.In order for an income statement to correctly and clearly show how the business is going, it needs to include all of the income from the business, and be offset against all of the expenses from the business, within a particular period of time. Depreciation is an expense, and like all other expenses, is deducted from income, leaving a net amount on which tax is payable. Depreciation reduces the amount of tax the business pays on its profit. However, depreciation never appears as cash in hand, as it is simply a book entry to record it. Because accounting is a "double-entry" system, meaning that for every debit there must be a corresponding credit, the other side of this book entry appears in the balance sheet, reducing the value of the corresponding asset.The most common methods of depreciation used are "straight line" and "diminishing value". The straight line method spreads the depreciation expense evenly over the life of the asset, while the diminishing value method allows a larger amount of depreciation to be deducted early in the life of the asset. In either case, the total amount of depreciation is the same. The question of which method to use depends on circumstances, and should be taken under advice from your accountant. Even though the second method may reduce the tax paid early in the life of the asset, it may not be the best for your circumstances.Accounting principles and taxation rules impact on depreciation and the rate which can be applied, so armed now with an understanding of how depreciation impacts on your business, you are in a much better position to approach Accountants and ask for their assistance in ensuring you get the best value from your depreciable assets.
