What is Depreciation and Why Does it Matter?
Depreciation is the gradual reduction in the value of an asset over time due to age, wear and tear, usage, or obsolescence. Assets such as buildings, machinery, vehicles, and equipment all lose value as they age, and depreciation allows businesses to account for this loss.
Normally, expenses are written off in full during the period in which they are incurred. However, fixed assets are generally held long-term, and their costs are spread out over their useful life through depreciation.
Key Methods of Depreciation
Several methods are used to calculate depreciation, each suited to different types of assets and business strategies. The most common include:
Straight-Line Depreciation: This method spreads the cost of an asset evenly over its useful life. It is simple and widely used when an asset's value declines at a consistent rate.
Declining Balance Depreciation: This method applies a higher depreciation rate in the earlier years of an asset's life. It is used when assets lose value more quickly, such as with rapidly outdated technology.
Units of Production Depreciation: Depreciation is based on the asset's usage or output, ideal for assets where wear and tear are directly tied to usage, like manufacturing equipment.
Why Depreciation Matters
Accurate Financial Reporting
Depreciation ensures that the costs associated with long-term assets are recognized gradually over their lifespan, aligning expenses with the revenue they generate. Without depreciation, a business could appear less profitable in the year an asset is purchased and more profitable in later years when the asset generates revenue without corresponding costs. Depreciation provides a clearer, more consistent view of profitability over time.
Tax Benefits
Depreciation has significant tax implications, allowing businesses to write off the cost of an asset over several years, reducing taxable income and lowering the amount of taxes paid. Tax planning around depreciation is often a crucial element of a business strategy.
Asset Management, Cash Flow, and Informed Business Decisions
Depreciation impacts financial statements by reducing taxable income without affecting cash flow, allowing funds to be reinvested into other operational needs. It is also important for planning asset maintenance, future investments, and determining when to replace assets with newer versions.
What You Need to Do
In most cases, calculating depreciation is handled by your CPA, while your bookkeeper ensures that asset values and depreciation expenses are recorded correctly on the balance sheet and profit and loss statement. It’s crucial to keep your bookkeeper, CPA, and CFO aligned regarding how depreciation is recorded and presented.
**One key aspect to note is that the way depreciation is calculated for tax purposes may differ from how it is presented to investors or banks when securing funding. Keep all financial parties informed about your intentions to ensure your financials are ready for any outside review. You want to maintain clear communication with your team to ensure proper financial reporting and tax planning.