The Generally Accepted Accounting Principles (GAAP) are the defining accounting guidelines for the U.S. GAAP is drafted by the Financial Accounting Standards Board (FASB), a private organization of accountants and experts in financial reporting. Depreciation is an expense recognized by GAAP which reflects that long-term assets used in business decrease in value over time due to use. Recording this expense accurately is vital to ensure that balance sheets accurately reflect the value of the assets a business owns.
Assess the value of the automobile. The value of the automobile equals the costs associated with acquiring it. This means the purchasing price plus any commission the business paid. Interest paid on debt taken to finance the purchase of the vehicle is excluded from calculating the carrying value of the car, as interest is expensed as it is paid.
Measure the car’s useful life. The useful life of any depreciable asset depends on how the owner of the asset defines it. The owner needs to consider how the car will be used and whether that will speed its deterioration as well as whether evolving circumstances may make the car inadequate for the businesses purposes. The IRS defines a car as having a five year useful life for calculating tax depreciation.
Calculate the annual depreciation expense by dividing the value of the car by its useful life. This is called straight-line depreciation.
Determine the appropriate first year depreciation expense for the car. A car is rarely purchased on the first day of the tax year. As a result, the owner cannot take a full year’s depreciation in the first year of ownership but only a percentage. This is calculated by multiplying the annual depreciation expense by the number of months the car was owned in the first year and then divided by 12. So, if a $10,000 car was purchased on May 1st, you would multiply $10,000 by 8, and then divide by 12. The depreciation expense for that first year would be $6,667.
Record the depreciation expense annually. When recording the car’s depreciation annually with a journal entry, debit depreciation expense and credit accumulated depreciation for the amount of the expense recorded for the year. Debits and credits are the two sides of a journal entry. Debits increase assets and expense accounts but decrease liabilities, equity and revenues. Credits do the opposite, decreasing assets and expense accounts, and increasing liabilities, equity and revenues.
John Cromwell specializes in financial, legal and small business issues. Cromwell holds a bachelor's and master's degree in accounting, as well as a Juris Doctor. He is currently a co-founder of two businesses.