If you’ve ever glossed over a company balance sheet, you’ll have noticed a line entry called ‘depreciation’, usually with a percentage attached. Businesses have used this category to describe their financial situation from time immemorial. But what does it actually mean?
By Team Savant
Let’s say that you have a fleet of trucks, and one of them requires a new K105906N50 EL1100 Knorr-Bremse EAC air processing unit for the brakes. In this case, you can say that the vehicle has depreciated because it needs a spare part — usually because of wear and tear.
Depreciation is something that affects practically every productive asset. Over time, equipment loses performance, and eventually, it fails.
Depreciation, however, is hard to measure. The truck mentioned above could work flawlessly for years on end and then experience a catastrophic failure that takes it off the road and requires massive expense. Accountants don’t chalk this up to a sudden depreciation. Instead, they see it as the cumulative effects of use spanning over several years.
Typically, companies will settle on a depreciation rate depending on their industry and the type of assets they own. Anything with moving parts tends to depreciate rapidly, and so has a higher rate. Things like buildings that just stand there have a much lower rate.
Why Businesses Are Obsessed With Depreciation
Image: Austin Distel
There are several good reasons why business is obsessed with depreciation. But fundamentally, it comes down to the issue of tax. The higher the rate of depreciation, the more money you can deduct from your expenses. After all, depreciation is a cost that you’ll eventually have to pay at some point in the future.
Please note that you cannot depreciate some assets. These include anything you use for less than a year, land, and personal property.
There are all sorts of things your business owns that you can depreciate. These include your company vehicles, buildings, plant, equipment, office furniture, electronics, and some intangible items, like patents.
Fundamentally, you need to own the asset, and your business must use it to generate income. You can’t, for instance, make a depreciation claim for trophies sitting on your office wall celebrating your company’s achievements. They’re the result of productive activity, not the cause of it.
Ways Of Depreciating Assets
There are several different ways of depreciating assets that the tax authorities will accept.
The first is called units of product depreciation. Here, you’re allowed to depreciate assets according to how much stuff they make. For instance, you might depreciate a pizza oven based on how many thousands of pizzas you cook with it.
Double-declining depreciation is another form that you can use that allows you to write off more of an asset’s value after you buy it. The goal here is to recover more of the asset’s value early on instead of waiting many years for its resale price to fall.
Straight-line depreciation is perhaps the simplest to understand. Here, you split the value of the asset among multiple years and then deduct the same depreciation expense annually.