Depreciation is one of those concepts that can be a little bit challenging for the average business executive or manager to understand. Although it is a required concept for the accountant to understand, it is a concept that doesn’t always come to the forefront in business management.
Depreciation, however, has an effect on net income – which can create some negative “surprises” for business leaders if they don’t anticipate its effect.
Let’s get to the definition, and then we’ll discuss how it applies to a business.
Depreciation is an accounting method of allocating the cost of a tangible asset over its useful life. Businesses depreciate over a period of years for both tax and accounting purposes. For tax purposes, businesses can deduct the cost of tangible assets they purchase as business expenses. Businesses must depreciate these assets within the rules of the IRS, especially about how and when deductions may be taken.
Now that we’ve covered the “official” definition, let’s cover the practical side of how depreciation affects a business.
Let’s say that you buy a brand-new delivery truck for $30,000. When you sign the papers and you drive the truck off of the sales lot, the value of that truck immediately changes. The truck isn’t worth as much after you leave. That’s an easy example of practical depreciation – the truck is worth less than what you paid for it. It might now be worth $27,000 if you tried to sell it right after you bought it.
Business accountants and the IRS also realize this concept. To deal with this situation, they account for a decreasing value on valuable assets. Depending on the allowable IRS schedule, the truck’s “book value” decreases every year. This concept makes a lot of sense. The truck is not worth $30,000 five years later, so we adjust for the loss of value. Therefore, we reduce the value of the truck through depreciation.
The reason why you as a business executive should understand this concept. The net income and the net value of a business is adjusted by depreciation every business’ fiscal year. As the accountant makes the annual depreciation calculations, the business will see the depreciation amounts reduce the net income of the business. The simple fact is that the assets of the business are not worth as much as they were at the beginning of the year.
There are a lot of accounting principles regarding depreciation that come into play that we won’t cover here. However, it’s good for you to understand the basic idea of depreciation and how it affects the profitability of your company.