SMALL BUSINESS RESOURCES

What is depreciation?

3 min read

There’s a lot of assumed knowledge in the business world, especially when it comes to financial and compliance matters. But what is depreciation and why is small business depreciation important to you?

You’ll probably have a good idea about depreciating assets, but when it comes to specifics around depreciation accounting and understanding what is depreciation schedules, it becomes a bit more complex.

Time to break it down.

Small business depreciation

When it comes to the management of business equipment and assets, understanding small business depreciation is paramount.

Put simply, depreciation is the devaluing of a material asset over a period of time.

When you purchase a work-related asset to run your small business, such as a work vehicle, that vehicle will inevitably drop in value over time due to wear and tear.

This devaluing of an asset is reflected in its market price and this is known as depreciation.

Calculating depreciation is a necessary step when deciding the value of a business and the ability to reduce tax and take advantage of incentives.

Most small businesses will work out how to depreciate assets with an advisor and have their accounting software automate the process for visibility and compliance.

Depreciation and profit

When you look at your yearly profit and loss statements (P&L) you can get a skewed idea of profit by not factoring in depreciation of your work assets.

If you didn’t depreciate your work vehicle correctly, it may seem you’re more profitable than you really are.

In this way, when not only calculating profitability but also the effective value of your business, depreciation is a primary variable that must be understood.

Depreciation and tax

This is where the advice of a trusted advisor is worth its weight in gold. Getting the best tax deal when it comes to dealing with the ATO is an important part of running a profitable business and depreciation is a big part of this.

By accurately depreciating your assets, you’ll pay less tax and subsequently have more free cash to run your business and build profits.

It’s always best to chat with an advisor about this. If you don’t have one, find an advisor near you with our free advisor search tool.

Simplified depreciation for small businesses

When approaching the topic of depreciation for tax purposes, there’s a simplified depreciation method for small businesses.

This involves the instant asset write off scheme, which has grown and morphed during the COVID-19 pandemic, so keeping up to date is essential. You can read our blog on using the instant asset write off here.

Under the ATO’s simplified depreciation rules:

  • You can utilise the instant asset write-off for every business-related asset you’ve purchased that cost less than the applicable threshold when it was either first used in your business or installed for use.
  • When purchasing equipment that costs more than the applicable instant asset write-off threshold, you can place this asset into a ‘small business depreciation pool’. Read more about depreciation pools here.

Again, making good use of a trusted advisor is encouraged when navigating shifting rules around the depreciation of assets and the instant asset write off scheme.

Different methods of calculating depreciation

There are also different methods of calculating depreciation you should be aware of. These are also acceptable methods of depreciation which may come into play for specific small business circumstances. More than likely, these will not be used by many small businesses, but an advisor may still recommend these methods.

Straight line depreciation

Straight line depreciation, otherwise known as Prime Cost depreciation, basically dictates that an asset will depreciate in value at a constant rate from the purchase price to zero.

This means that every year an asset will be depreciated at the same rate in any income year.

Diminishing value depreciation

The diminishing value depreciation method involves depreciating an asset at different rates depending on the point of its life cycle. By using diminishing value depreciation, you’ll depreciate an asset more in the first few years than the later part of the asset’s life.

The ATO has provided a tool which compares the two methods here.

Free financial guide

Get a handle on the various terms and processes involved with the financial management of your small business with our in-depth guide.