Understanding the Meaning of depreciation
You don’t have to know how to calculate depreciation, but it will benefit you to know the meaning of depreciation and how it affects your small business.
This page explains how depreciation reduces your tax liability and why it is done this way.
the meaning of depreciation main facts
- Depreciation is a deductible business expense.
- It reduces the cost of fixed assets by percentages over several years.
- It decreases your profit.
- It lowers your tax payments.
- There are different methods.
- It has to be tracked in a schedule.
The meaning of why depreciation is used
Many businesses purchase high cost equipment which is:
- owned by the business and
- used in the business for more than 12 months – such as a vehicle or a high-end printer or a forklift
The purchase price of a fixed asset is not allowed as an immediate deductible business expense, unless it is under a certain cost (see next section Asset Value Limits).
This means you cannot immediately enter the full cost as an expense in your bookkeeping accounts to show on your Profit and Loss.
This is because an asset has a long-term benefit to a business, so rather than claiming the full expense immediately in the year it is purchased, the tax laws require the cost to be spread over the perceived life of the asset which could be from 2 years to 10 or more years.
An asset can potentially help a business bring in income over many years, therefore it makes sense for the cost of the asset to be spread over many years too, which aligns with the accounting principle of matching expenses to income within the same time frame as each other.
The value of the asset will decline with use and wear over the years and so depreciation aims to reflect that decline in the accounts via the reduction of the cost over the years too.
So instead of claiming this year the full purchase price of the asset by entering it as an expense, only a percentage of that price is entered as an expense (the depreciation) and this same percentage is used each year to reduce the cost until the asset is no longer of value.
If a business claims this year the full cost of an asset, which could be thousands of Dollars or Pounds or Euros (wherever you are from) it will have a huge impact on the current year’s profit, perhaps even showing a loss, which does not give a realistic picture of the day to day trading of the business – these large one-off purchases are not a regular operating expense.
When equipment is expensed it is entered on the Profit and Loss as an expense with its full value.
When equipment is capitalized it is entered on the Balance Sheet as an asset – then depreciated by annual portions of its full value.