Depreciation prevents expense spikes

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The Internal Revenue Service stipulates that businesses must capitalize expenditures for big-ticket items and recover that cost over several years – a practice known as depreciation – to avoid dramatic changes in the financial statements of a business from one year to the next. Knowing when to depreciate and when to claim a special one-time expense deduction is critical for entrepreneurs.
Capital expenditures offer businesses an opportunity to expand operations — to modernize and grow — by buying the equipment and capital they need and deducting these costs on their income tax return. This fuels economic expansion.
Depreciation makes sense when a business makes a major capital investment that offers long-term benefits, but is purchased upfront or over the short-term. Typical candidates for depreciation include vehicles, buildings, furniture, equipment, and computer systems. Rather than frighten investors by recording the whole impact of a purchase in one financial period, where it can create a loss, a company can spread it out over many financial periods effectively matching the deduction to the period of benefit. It matters not how the loan is repaid; what matters is how long the investment is expected to provide an economic benefit.
For example, if the business purchases a factory item that’s likely to generate revenue for five years, the cost to purchase that item can be spread out over the estimated useful life of the item rather than showing up as a one-time cost in one financial period.
From an accounting perspective, the debt incurred for large capital expenses is normally amortized over the life of the note. Here, payments are partially interest and partially principal, with a larger amount of each payment going toward interest at the beginning of the amortization period and a greater amount dedicated toward principal near the end of that period.
Amortization protocol can get confusing when it comes to online businesses. If an online business buys its website from a contractor who has an economic stake in the website’s performance, the design costs are amortized over three years, beginning the month the website is placed in service.
If the company develops its website design, or hires an independent contractor to do it without assuming any risk, the company launching the website can deduct the costs in the year they’re paid or amortize them under the three-year rule.
For 2012, non-customized computer software placed in service during the year is entitled to the Section 179 special expense deduction, which can be written off in full when the expense is incurred.
Depreciation and amortization – the voluminous rules, regulations and calculations – can be daunting for business owners, but it is in the business’s best interest to seek advice from a CPA for help with successfully navigating these potentially hazardous waters.

Jimmy Pendergrass is a CPA and Partner-in-Charge of Pratas, Smith & Moore LLC, a wholly owned member of Accounting & Consulting Group LLC, which has offices in Albuquerque, Alamogordo, Carlsbad, Clovis, Hobbs and Roswell. To learn more about Accounting & Consulting Group, visit www.acgnm.com.
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