You often hear about depreciation in reference to your taxes. What exactly is it though? Is it important? How does it affect your business? In this article, we will discuss what depreciation is and why should you care about it. Our goal is to make this mysterious accounting term easier to understand.
What is depreciation?
What does that mean?
When you purchase long-term (fixed) assets, those assets will generate revenue for your business. However, the truth is that no building, vehicle, or piece of equipment will last forever. They will eventually need to be replaced. As a fixed asset ages, it incurs a cost to the business. Depreciation represents the use of a fixed asset over its useful life.
There are various methods of depreciation that can be used, and we won’t go into all of them here. Fair to say that depending on the type of fixed asset and its estimated useful life, your tax professional will provide the best recommendation of which method is best to use.
Why it’s good for your business
Depreciation is an expense often ignored by business owners. After all, it doesn’t involve losing cash. So why should you care about it?
Depreciation affects your net income. Accounting is the language of business. So when examining your net income, you want all revenue and all expenses to be included for an accurate financial picture.
If you have fixed assets on your balance sheet but no depreciation recorded, your net income will be overstated. In other words, you will think that your net profit is higher than it actually is. Conversely, if you record fixed asset purchases as expenses, your net profit will similarly be distorted. You will think you are generating less profit than you actually are.
Depreciation impacts the value of your business. Depreciation helps determine how much your business is worth. For example, a construction company with older equipment is less valuable than a similar company with newer equipment. Why? Because newer equipment means a company can use the equipment to generate revenue over a longer period of time.
An added benefit is that business owners can determine when certain fixed assets need to be replaced. The purpose of fixed assets such as computers, equipment, or vehicles is to help generate revenue. It’s far better to replace a piece of equipment before it becomes completely obsolete.
How it can bring tax benefits
One of the best benefits depreciation brings to small businesses is tax benefits. While our firm does not specialize in tax services, we know that depreciation can be part of a healthy tax strategy. Here’s why:
- It is a deductible business expense for both Schedule C and corporate tax filers
- Certain types of fixed assets are eligible for modified/accelerated methods of depreciation
- There are provisions for special tax deductions related to depreciation (Such as Section 179 rules)
In any discussion involving the use or purchase of fixed assets, we recommend reaching out to your tax professional to determine the impact these transactions may have on your tax situation.
Hopefully this article helped you to view depreciation from a new perspective. Interested in learning more about managing your fixed assets? Check out our other article discussing the difference between fixed assets and expenses.