How do I handle depreciation and amortization?

We're all familiar with the idea that when we buy a car, or a television, or any other large item, it depreciates — it becomes worth a bit less every year. When you buy larger assets for your business, you need to keep track of the value of the asset, which is a bit less each year, and also account for the depreciation, which is part of your business expenses.

This article explains how to account for depreciation. It's important to be aware, however, that how much of the value of each asset you can depreciate and set off as an expense for calculating taxable profits each year is governed by the tax rules in your particular jurisdiction, so be ready to talk to an accountant or spend some time researching the rules where you are to ensure you depreciate the correct amount.

Understanding Depreciation

Think about your office printer. When you buy paper, you'd normally categorize that as an expense. Paper is inexpensive, and you'll generally use it up within the year, so it would make no sense to try and track the value of a few hundred sheets of paper as an 'asset', even at the year-end.

But what about the printer itself? That could be a different matter. Let's say you have bought an advanced, expensive color laser printer, which you expect to last several years. That is an asset: it's going to generate value in your business over more than one accounting period.

A key concept in accounting is the matching principle: we try to match expenses with the income to which they relate. So to work out this year's profit, you don't want to count the whole of the cost of the printer against this year's income; you what to match only the bit of the cost of the printer that relates to this year's usage against this year's income.  The bit of the cost that wasn't "used up" this year is carried forward as part of the assets of your business, to be used up in future years.

The bit of the cost that you record as part of your expenses in a particular year is referred to as depreciation.

This raises a question: How much of the cost should I record as an expense each year? Unfortunately, there is no single, simple answer to this question. The business and accounting logic is that you should depreciate every asset over its useful life, so a sensible approach could be to estimate that you will keep the printer for four years, and will charge 25% of its value as a depreciation expense each year. If you are trying to prepare your accounts for the purpose of calculating tax, however, you may find that the tax authority in your jurisdiction as decided that printers should be depreciated over 10 years, or conversely they may allow 100% deduction in the year of purchase, because your government wants to encourage investment in technology!

Applying the correct depreciation for tax purposes is complicated, because rules may change, and there can be different rules for different types of asset, and for different types or ages of business. Because of this, Wave recommends that you:

  1. Talk to an accountant early in the life of your business to determine how to account for depreciation in your specific situation.
  2. If you don't yet have an accountant and want to account for depreciation, simply follow the principle set out above and divide the purchase cost of the asset over the number of years you expect it to last in your business; deduct that amount each year.

If you take the second route, the profit you calculate for your business is very unlikely to be exactly what you need to declare for tax purposes.  When you do start to work with an accountant, he or she will figure out how depreciation should have been calculated for tax purposes and will make some additional accounting entries for you to capture any difference in tax payable.

Recording Depreciation in Wave

Let's continue with the printer example discussed above. We'll assume you bought a high-end color laser printer for $2,000, and you expect it to last 4 years. You have decided to depreciate the printer in four equal amounts of $500 each year.

  1. First, you want to categorize the purchase of the printer into an Asset account. However, the account is not set up by default, so you must make your own. Go to Accounting on the left-hand side and click Chart of Accounts. You need to create either one of the following two options:
    1. Machinery, equipment, furniture & fixtures. This account allows you to lump all depreciated items together; for example, your new printer, as well as your camera and your scanner, could all go in here together, or
    2. Other Long-Term Assets. This allows you to rename and customize the account for individual items; for example, you could create an account just for your printer.
    For this example below, we chose Other Long-Term Assets and renamed it Other Long-Term Assets: Printer.
  2. Select Assets then click Long-Term Assets. From the list, choose Other Long-Term Assets and rename it.
  3. You will also need to create Accumulated Amortization of Machinery, Equipment, Furniture & Fixtures. This allows you to track your depreciation expenses in Journal Transactions, which we will use later on. You will find this account in the same place as Other Long-Term Assets (see screenshot above.)
  4. Once you've created those two accounts, you're ready for the next step. Select Purchases on the left-hand side, select Bills and then Create a bill.
  5. Choose or create a vendor, as you normally would. Choose an existing Product from the drop-down menu, or add a new one. In this example, we created a new product called Printer.
  6. Choose Other Long-Term Assets: Printer as your Expense account.
  7. Click Save.
  8. Now you want to depreciate the expense for each year.  To do this, we'll use Journal Transactions. Go to Accounting on the left-hand side then select the top tab Journal Transactions. Finally, select Add transactions.
  9. Since the entire amount is currently categorized as an asset, our goal is to reduce the asset's net value each year (net value = purchase cost - accumulated amortization).

    In this example, we have decided to depreciate the printer by $500 each year for 4 years (but at the risk of repeating ourselves, it would be a great idea to discuss this with an accountant first!) To record the journal transaction, enter the depreciation amount for the year ($500) in a row for Depreciation Expense. Under the Debit column, type the amount that has been depreciated.

    On the next row, we choose the Accumulated Amortization of Machinery, Equipment, Furniture & Fixtures account, and under the Credit column, record the balancing $500 credit. Both sides should equal, indicated by the Total values.

Let's continue with the printer example discussed above. We'll assume you bought a high-end color laser printer for $2,000, and you expect it to last 4 years. You have decided to depreciate the printer in four equal amounts of $500 each year.

  1. First, you want to categorize the purchase of the printer into an Asset account. However, the account is not set up by default, so you must make your own. Go to Accounting on the left-hand side and click Chart of Accounts. Create a new account under Other Long-Term Assets. This allows you to rename and customize this account for individual items; for example, you could create an account just for your printer. For the example below, we chose Other Long-Term Assets and renamed it Other Long-Term Assets: Printer.
  2. Select Account Type and under Assets click Other Long-Term Assets.  In the Account Name field enter "Other Long-Term Assets: Printer.
  3. You will also need to create a Depreciation and Amortization account. This allows you to track your depreciation expenses in Journal Transactions, which we will use later on. You will find this account in the same place under the Asset field.
  4. Once you've created those two accounts, you're ready for the next step. Select Purchases on the left-hand side, select Bills and then Create a bill.
  5. Choose or create a vendor, as you normally would. Choose an existing Product from the drop-down menu, or add a new one. In this example, we created a new product called Printer.
  6. Choose Other Long-Term Assets: Printer as your Expense account.
  7. Click Save.
  8. Now you want to depreciate the expense for each year.  To do this, we'll use Journal Transactions. Go to Accounting on the left-hand side then select the top tab Transactions. Finally, click the down arrow next to the + icon on the top right corner and from the drop-down select Add Journal Transaction.
  9. Since the entire amount is currently categorized as an asset, our goal is to reduce the asset's net value each year (net value = purchase cost - accumulated amortization).

    In this example, we have decided to depreciate the printer by $500 each year for 4 years (but at the risk of repeating ourselves, it would be a great idea to discuss this with an accountant first!) To record the journal transaction, enter the depreciation amount for the year ($500) in a row for Depreciation Expense. Under the Debit column, type the amount that has been depreciated.

    On the next row, we choose the Depreciation and Amortization account, and under the Credit column, record the balancing $500 credit. Both sides should equal, indicated by the Total values.

You're done for now! Since the item depreciates each year, you must create a new Journal Entry like this each year until you have depreciated all of it.

Remember, too, that if you sell or dispose of the printer for more than its documented value (i.e. the purchase cost less all the depreciation amounts) then you will need to account for either a gain or a loss on disposal.