Depreciation Basics
January 24th, 2010 Filed under: Uncategorized — Accounting Author
When a small business owner is just starting to look at his profit and loss statement, depreciation is often something he feels doesn’t belong. I’ve spent many hours in my practice explaining the reason for the depreciation expense to business owners who thought it was only “for taxes”. So, I thought I’d write a short primer on depreciation expense and hopefully clear up some common misconceptions.
Even though many small businesses don’t show depreciation on their books, it’s not because it doesn’t belong there. Rather, it’s the function of their bookkeeping, often performed by someone not familiar with how depreciation is calculated. In all these cases the only time depreciation is even mentioned is when tax time rolls around and the tax accountant brings it up for the purposes of calculating the tax return. But depreciation is an integral part of your accounting and should be shown on your financial statements for reporting purposes – depreciation expense belongs on on the profit and loss statement and accumulated depreciation on your balance sheet.
What is depreciation?
Depreciation is the way accountants match revenues with the costs needed to produce them. This “matching principle” is one of the basic principles of accounting. When you purchase an asset, it’s as if you prepaid for something that will help you generate revenues over a long period of time. Depreciation expense is the way in which this contribution to your revenues is recognized in your financial statements.
Since many business owners think of profits only in terms of cash, depreciation is hard to conceptualize since it doesn’t involve cash until much later in the life of that asset. Eventually, when time comes to dispose of it, depending on its market value at the time, you will either generate a loss or a gain.
How are assets depreciated?</b>
There are several depreciation methods, but the basic two are: straight line and MACRS. Both are allowed for both book and tax purposes. By the way, you can use a different method for your book (financial reporting) purposes than the one you will use for your tax return. It’s easier, however, to use the same method for both. It makes for easier accounting.
MACRS vs. Straight-line depreciation
MACRS is an accelerated depreciation method, which means that you can deduct larger depreciation expense early on in the asset’s life. Straight line, on the other hand, spreads the depreciation expense evenly over the life of the asset. Total depreciation will be the same, regardless of the depreciation method you use.
Even though many people opt for tax savings right away and use MACRS, if your business is young, chances are you will need larger depreciation deduction later on, when your profits increase. Your early years will most likely see losses and large deductions may not be as needed then.
In future articles I will go into more depth about both depreciation methods and how the calculations are performed.
Lucy Rudnicka is a former Corporate Controller. She now owns her own Accounting Services firm – “FINANCIALS for You” – and works primarily with small businesses by providing them with outsourced bookkeeping, business plan consulting, part-time Controller services and professionally designed financial templates.
She believes that every business, no matter how small, needs accurate and timely financial statements. Once those financials are available, you can start analyzing your results with financial ratios. Download a profit and loss template with ratios and start looking at your business differently today!
One Response to “Depreciation Basics”
By Marc Adams on Jan 30, 2010 | Reply
Hi Lucy,
I really, really love this article. Most of my small business clients don’t even bother to review their financials so I don’t stress the depreciation portion until tax time. Your article has made me decide to change my thought process, to include it monthly and emphasize the importance of it when I review their reports with them.
Thank you.