What is depreciation and why should I care?

Small Business Guides

5 min read

Depreciation affects your bottom line, your tax bill, and the value of your business. Those are three good reasons to learn what depreciation is and how it works. Here are the basics.

What is depreciation?

Depreciation is what happens when a business asset loses value over time. A work computer, for example, gradually depreciates from its original purchase price down to $0 as it moves through its productive life.

There are techniques for measuring the declining value of those assets and showing it in your business’s books. This area of accounting can get complex so it’s a good idea to work with a professional.

Purpose of depreciation: 3 main functions

Depreciation accounting helps you understand the true cost of doing business (because wear and tear is an expense), reduce your tax bill, and estimate the value of your business.

1. Depreciation as an expense (cost of doing business)

To understand how profitable your business is, you need to know all your costs. Depreciation is one of those costs because assets that wear down eventually need to be replaced.

Depreciation accounting helps you figure out how much value your assets lost during the year. That number needs to be listed on your income statement, and subtracted from your revenue when calculating profit. If you don’t account for depreciation, you’ll underestimate your costs, and think you’re making more money than you really are.

2. Depreciation and tax

Because depreciation lowers your profit, it can also lower your tax bill. If you don’t account for depreciation, you’ll end up paying too much tax.

You can gradually claim the entire value of an asset off your tax. However there are rules around how quickly you can depreciate certain assets from a tax perspective.

3. Valuing your business (depreciation on the balance sheet)

As assets lose value, so can your business. A transport company with old trucks may not be worth as much as a transport company with new trucks, for example. Your assets are listed on your balance sheet, on what is called the fixed asset register. Make sure you update the register whenever you work out depreciation. It's also worth remembering that assets are often used to secure loans. As they drop in value, they offer less security, and you may find it more difficult to get finance.

What can be depreciated?

While most business expenses are tax-deductible, they’re not all depreciable. There’s a difference. Consumables like stationery can be deducted from tax but you have to claim for them in the year you bought them. For most businesses, only fixed assets can be depreciated.

What are fixed assets?

A fixed asset is something that will help you generate income over more than a year. It includes things like tools, machinery, computers, office furniture, vehicles, and buildings. You don’t always have to own them. Some leased items may be depreciable, too.

Intangible assets, which are non-physical things like patents and copyrights, can also be depreciated (or amortized). They’re incredibly valuable to your business and that value gradually shrinks as they near their expiry.

If an asset doesn’t lose value – such as land – then it can’t be depreciated. Nor can inventory. That is dealt with separately, under the field of inventory accounting.

A muddy red four-wheel motorbike showing signs of wear and tear, and depreciation.

Depreciation is how you account for wear and tear on equipment.

Choosing a depreciation schedule

To depreciate an asset, you must first estimate its lifespan. A computer might only last three years. A kiln in a factory could last 30. The GAAP (generally accepted accounting principles) provides some guidance on how fast to depreciate certain assets, and the IRS has some rules too. Some businesses keep two depreciation schedules – one for tax purposes, using IRS rules, and one for the business books.

An asset’s value can be adjusted to zero at any time if it’s lost, stolen or damaged. It can also be sold, traded or combined into a new asset.

Methods of calculating depreciation

You also need to decide how an asset’s value will decline over its lifespan. Will it lose most of its value early, or will it lose value at the same rate every year? There are many different methods of calculating depreciation, and some of them are quite complex. Three of the most common are:

Straight line depreciation

Under this method, the asset depreciates the same amount every year, till it has zero value. For instance, an asset expected to last five years would depreciate by one-fifth of its ticket price each year.

Diminishing value depreciation

Under diminishing value depreciation, an asset loses a higher percentage of its value in the first few years. That rate of depreciation gradually slows down as time goes on.

Units of production depreciation

The lifespan of some assets is better measured by the work they do than by the time they serve. For example, a vehicle might travel a certain number of miles, or a packaging machine might box a certain number of products. You could depreciate these assets based on usage rather than age.

Depreciation for small business

Depreciation can seem tricky at first, but it’s nothing to be scared of. It will help you better understand your costs and lower your tax bill, which are good things.

It doesn’t have to be complex either. Most businesses simply adopt the depreciation schedule provided by the IRS. Once it’s set up in your accounting software, the math happens automatically and the numbers flow straight through to your tax return. And, as always, an accountant or bookkeeper can provide advice along the way.