You bought a computer with a high speed processor, extra memory, and disk space, for $3000, to serve as your small business server. Let us walk through how you will account for the purchase of the capital asset initially and how you will account for the depreciation expense each month:
- Create a new account called Office Equipment with Account Type as Asset and Parent Account as Assets.
- On the date of purchase make an entry showing an Increase of $3000 in the Office Equipment account and select the Checking Account in the Transfer column.
- We are going to apply a straight-line method of $50 depreciation per month over the 60 month period. This is just an example. More details follow in this section about what depreciation rates are allowed by tax laws. On the last day of the month, create a transaction in the Expenses:Depreciation account showing an expense of $50 and select the Office Equipment account as the Transfer account as shown in the following screenshot:
By charging 1/60 of the capital cost each month as depreciation, at the end of the 60 month period, you would have written off the entire value of the capital asset.
Tip
Handling repetitive transactions easily
You may find it convenient to set up a scheduled transaction for creating a monthly depreciation entry for each asset.
Typically the Internal Revenue Service (IRS) in US allows you to write off capital assets over the following period:
- Some manufacturing tools: 3 years.
- Computers, office equipment, cars, and construction equipment: 5 years.
- Office furniture and appliances: 7 years.
- Commercial buildings: 39 years.
The above are just broad indications for you to get the overall picture. IRS also allows you to choose either a straight line or a declining balance method of depreciation. In the straight-line method the cost of the asset is depreciated over the life of the asset in equal amounts per year as shown in the following screenshot:
In the declining value method, the depreciation is a fixed percentage of the book value. The book value starts as the cost of the asset in the first year. In subsequent years, the book value is the previous year's book value less depreciation for that year. The following screenshot shows the same asset seen in the earlier example, if we apply the declining value method of depreciation:
Note
Under certain conditions IRS allows you to deduct the entire cost of an asset in the year you acquire the asset and start using it for business. There are also accelerated depreciation methods that allow more depreciation in the initial years and progressively less later. For new assets put into use in 2009, the US Congress has approved special 50% bonus depreciation. Therefore, you should consult an accountant or a tax consultant to find out what are the best options for your specific situation.
Land, though a capital asset, is typically not allowed to be depreciated.
Tip
You can capitalize all the associated costs
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, its shipping costs, installation costs, and training of your staff to operate the machine, all these costs can be included in the cost of the equipment.
- What type of account is a depreciation account?
a. An asset account.
b. A liability account.
c. An expense account.