Depreciation is a concept that is often not fully understood by many business owners. Let’s start with an understanding of assets, because this is essential to understanding depreciation.
An asset is a resource that is expected to produce future economic benefits for a business. It is something that assists a business directly or indirectly in generating revenue. This could be machinery used for manufacturing goods sold to customers, a motor vehicle for a sales representative or a printer used by the administration department. Purchases of assets are treated in two different ways in the accounts of a business depending on whether the asset is expected to have a useful life beyond a year and also depending on its cost exclusive of GST. It is this classification that defines whether an asset will need to be depreciated or whether an immediate tax deduction can be claimed. (To understand the benefits of a write-off, or tax deduction, please see my article The Value of a Lost Receipt.)
The Australian Taxation Office changes the asset cost threshold regularly, so the treatment of the purchase of exactly the same asset may be different from one year to the next. A recent example is the announcement in the 2015 budget of an immediate write-off of assets under $20,000. Up until that point in time, small businesses could claim an immediate tax deduction for assets that cost less than $1,000 but now an immediate tax deduction can be claimed for assets that cost less than $20,000.
Items of a higher value, (depending on the current threshold), cannot be claimed as an immediate tax deduction in full in the year of purchase, but rather a portion of the cost can be claimed as a tax deduction over a period of a certain number of years. This is the definition of depreciation. Depreciation is not an entry for the decline in value of the asset so much as an apportionment of the cost of the asset over time. Here’s an example of an asset worth $30,000 depreciated over 3 years using the straight line method to give you a picture of how this works.
|Asset value at beginning of year
|Asset value at end of year
If you purchased an asset worth $30,000 it would sit on your Balance Sheet as a fixed asset. It would not affect your Profit & Loss statement, and therefore your profit, until such time as your accountant calculates the depreciation for the year. This typically happens after the end of the financial year when the tax return and annual financial statements are prepared. Depreciation is simultaneously a negative asset, (therefore reducing the value of the asset on your Balance Sheet), and an expense. It is the expense that becomes your tax deduction by reducing your profit and thus your tax.
Although almost all assets are eventually fully depreciated, (land being one such exception), it is the time span of the depreciation that matters, particularly to businesses making a profit. Such businesses want to maximise their deductions to reduce profits and therefore the tax that needs to be paid. Although the same amount of tax will need to be paid irrespective of the depreciation rules, the timing can vary depending on the depreciation rules. We all know that a dollar today is worth more than a dollar next year, which is why many business owners aim to bring forward their deductions and thus minimise their tax in the current financial year.