What is depreciation in accounting?

What is depreciation?

In accounting terms, depreciation reflects the gradual decrease in the value of a physical asset over time due to wear and tear, obsolescence, or other factors. Depreciation is the method of distributing the cost of that asset over its useful life.

For example, an industrial-grade oven is likely useful for years beyond when it was purchased. Depreciation would allow you to spread the cost of the oven over 10 or so years, portraying a more accurate view of business profitability during different accounting periods.

The importance of depreciation

Declaring the depreciation of assets is crucial for small businesses for a few key reasons:

Tax advantages

Depreciation is a tax-deductible expense in Australia and many other countries. By declaring depreciating assets,  businesses can reduce their taxable income, which translates to lower tax bills. This frees up valuable cash flow that can be reinvested in the business for growth, marketing, or hiring new employees.

Future investments

Depreciation helps with planning for future asset replacements. As you depreciate an asset, you’re essentially accumulating funds (on paper) over its useful life. This provides a good estimate of how much you might need to save or budget for to replace the asset when it reaches the end of its usable life. For example, if a computer depreciates by $200 per year, after five years, you’ll have “saved” (on paper) $1,000 which can be a good starting point for budgeting for a new computer.

Loan applications

When applying for loans, lenders look at a business’s financial statements to assess its stability and ability to repay the loan. By reflecting depreciation, your financial statements will show a more accurate picture of your business’s profitability and overall financial health, potentially increasing your chances of loan approval.

How to calculate depreciation

There are several methods for calculating depreciation, each with its own advantages and disadvantages. Here are three common methods used for depreciating assets:

Straight-line method

This is the simplest and most common method of depreciation. It spreads the cost of an asset evenly over its useful life. Here’s the formula:

Annual Depreciation Expense = (Asset Cost – Salvage Value) / Useful Life

In this formula, Asset Cost refers to the original purchase price, while Salvage Value is its estimated value at the end of its useful life. To get the value for Useful Life, figure out the number of years the asset will be in business use based on industry standards and quality.

Advantages:

• Easy to understand and implement.
• Provides a consistent depreciation expense throughout the asset’s useful life.

Disadvantages:

• Doesn’t consider the declining value of an asset over time. Most assets tend to depreciate faster in their early years and slower in their later years.
• May not accurately reflect the true cost of using the asset in each year.

Double-declining balance method

This method accelerates depreciation in the early years of an asset’s useful life. The depreciation rate is a fixed percentage (typically double the straight-line rate) applied to the remaining book value (cost minus accumulated depreciation) of the asset each year.

Advantages:

• More closely reflects the faster decline in value of assets in their early years.
• Offers a higher depreciation expense in the early years, which can be beneficial for tax purposes.

Disadvantages:

• Can result in a higher total depreciation expense compared to the straight-line method.
• Assets might not be fully depreciated by the end of their useful life, requiring a switch to another method in the later years.

Sum-of-the-Years’-Digits Method (SYD)

This method assigns a higher depreciation expense in the earlier years of an asset’s useful life and gradually decreases the expense over time. It considers the sum of the digits of the asset’s useful life.

Advantages:

• Provides more depreciation in the early years compared to the straight-line method, but less aggressive than the double-declining balance method.
• Easier to calculate compared to the double-declining balance method.

Disadvantages:

• More complex to understand and implement than the straight-line method.
• May not be as beneficial for tax purposes as the double-declining balance method.

Depreciation encourages small businesses to make well-informed decisions when purchasing assets. Knowing that the cost will be spread out over time might make them consider a more durable or higher-quality asset, even if it has a slightly higher initial price tag. This can lead to long-term savings and increased efficiency in the long run.