What depreciation is
In basic terms, depreciation reflects the reduction in value of your business assets over time. For example when you buy a car, its value reduces as soon as you drive it off the yard — depreciation reflects this reduction in value.
How it's calculated
Depreciation is calculated based off a set of tables provided by the IRD. These tables cover every asset imaginable, from the walls in a building, to office equipment, x-ray machines, dental drills and more.
The IRD calculate how long they think the asset will last (in years), and then calculate a depreciation rate. So, if they think the asset will last 10 years, then you can depreciate 10% per annum.
So, the more assets your business owns, the lower the tax bill.
However....and this is a significant however...
you still need to pay for the asset, which comes with a cost. Factor in the cost of the asset and the tax deduction isn't 'free' so to speak.
When you sell
Now this depreciation rate is only an estimated rate, based on what the IRD expects. When you sell the asset, a wash-up is done between the depreciation claimed and the actual loss on the asset over the period you've owned it (so, the difference between what you paid, what you sold if for, and the depreciation you've previously claimed).
If you scrap the asset, or throw it away, any value that the asset has in the books is written off.
Which assets get depreciated
Any asset you buy which is worth $500 + GST or more gets depreciated. Assets under $500 + GST get claimed as an expense.
Impact on your taxes
The nice thing with depreciation is that it's not a cost you pay in cash — once you've bought the initial asset.
Once you've bought the asset, you claim the depreciation as an expense. This drops your net profit, which in turn drops your tax bill.
So, the more assets your business owns, the lower the tax bill. However....and this is a significant however...you still need to pay for the asset, which comes with a cost. Factor in the cost of the asset and the tax deduction isn't 'free' so to speak.
Depreciation is a real cost
Many people look at depreciation as not being 'real'. In fact, many banks will ignore it as a cost when assessing whether you can afford to take on a loan. In our view, frankly, this is nuts (in most cases).
Imagine this — you get a $50,000 loan to buy a $50,000 car. The car drops in value each year. Along the way you've got to make repayments on the car — these repayments don't get picked up as an expense.
So, if you don't pick up the repayments as an expense, and the depreciation is ignored as an expense then the car is essentially free (from an accounting perspective). Crazy logic, but it's the logic many people run with.
The other way of looking at it is that you need to be constantly investing in new plant and equipment for your business to keep things ticking over. The depreciation on your Profit & Loss Report can be simply viewed as the cash you need to keep reinvesting in your business.
Depreciation is a real cost that your business needs to factor in and budget for. It's a cost which helps drop your taxes, but is a real cost year-to-year. Budget for it, and then know how much you can afford to reinvest in your business each year.
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