Businesses need to charge depreciation for accounting and compliance purposes. It is a method to allocate the costs of a fixed asset over several accounting periods.
Depreciation helps a business in several ways including asset valuation, tax benefits, and cost allocations. A business can use any depreciation method. However, tax regulatory authorities require following a specific method.
Let us discuss why do businesses depreciate assets.
Depreciation – Definition
Depreciation is an accounting method to allocate the cost of a fixed asset over its useful life. If the fixed asset is tangible, it is called depreciation. For intangible assets, it is amortization with the same accounting rules.
Depreciation helps businesses to recover the cost of fixed assets as they are used over years. It also lets them follow the accounting and taxation rules.
Fixed assets involve large costs. Businesses can either expense them at once with full costs or spread the costs over years. Accounting regulations also restrict businesses from charging the full cost of a fixed asset in a single accounting period.
In short, the depreciation method allows a business to recover the cost of a fixed asset as well as helps in compliance with regulations.
Depreciation basis is the rules for allocation of depreciation expense for a business. There are three main aspects of depreciation basis.
It is the most commonly used basis of allocation depreciation expense. The useful life of a fixed asset refers to the time for which the asset remains useful for a business.
In simple words, the useful life of a fixed asset is the usefulness of the asset. A business makes informed estimates about the useful life of an asset using historic information and comparisons.
The cost of the fixed asset includes purchase price, shipping charges, and sales tax. When allocating depreciation expense, a business will include all costs associated with the acquisition of an asset.
It is the price of a fixed asset at the end of its useful life. If the fixed asset is not useful for one business, it may have some value left for another. That’s the reason a fixed asset may have some residual or salvage value even after the use of several years.
Why Do Businesses Depreciate Assets? – Top Reasons
As mentioned above, depreciation helps a business with compliance and accounting treatment of fixed assets.
Let us discuss in detail the key reasons why businesses choose to depreciate assets.
Compliance with Accounting Standards
The top reason for any business to adopt the depreciation method is to follow accounting standards. Large fixed assets costs cannot be expensed in a single accounting period.
Compliance with accounting and tax laws for depreciation purposes may vary by jurisdiction. However, the main principle behind the depreciation accounting to spread the cost remains the same.
Wear and Tear of Assets
Fixed assets go through wear and tear for several reasons. It can be due to usage or natural loss of value over time. Either way, a business would need to recover the costs of a fixed asset before it becomes obsolete.
Limited Usage Rights
In certain cases, a business may acquire a fixed asset with limited usage rights. These assets may be on the lease or with a contract for a finite period.
Depreciation allows a business to allocate correct costs of fixed assets with limited usage rights.
Recovery of Maintenance Costs for Fixed Assets
Fixed assets require substantial maintenance costs. Depreciation allows a business to allocate correct maintenance costs. It also helps them in accounting for these costs correctly by associating the costs with the fixed assets.
Accurate Profit Calculations
Depreciation spreads the costs of fixed assets over several accounting periods. It matches the costs with the accounting benefits arising from the usage of a fixed asset. It means a business can calculate accurate profits by using depreciation accounting.
Another key reason for adopting the depreciation method is to comply with tax regulations. Tax regulatory authorities such as the IRS calls for the allocation of depreciation costs using specific methods.
Tax authorities also set threshold amounts and guidelines for setting the useful life of an asset. Thus, a business ensures to follow tax laws by adopting correct depreciation methods.
Accurate Picture of Fixed Assets for Stakeholders
Once depreciation starts accumulating, stakeholders of a business such as managers and shareholders can see an accurate picture of fixed assets.
Accumulated depreciation and yearly depreciation expenses help in the allocation of budgets and recovering costs of fixed assets.
Why Depreciation is Important for a Business
Depreciation is an accounting practice. It does not involve actual cash flow. However, it offers several benefits to a business for expensing fixed assets.
Let us discuss a few important aspects of depreciation for a business.
Depreciation lowers your tax bill. However, you cannot deduct any amount randomly to reduce the tax bill. You need to follow one of the allowed depreciation accounting methods and deduct the depreciation expense accordingly.
You do not make a cash-out flow transaction with the depreciation expense. Yet you can charge an additional expense and lower the tax amount.
Asset valuation becomes easier and accurate when you charge depreciation expense for a fixed asset. With yearly expense, you can spread the total cost of an asset over several accounting periods.
Accumulated depreciation can show the recovered cost and the remaining balance.
Depreciation is a useful method to recover the costs of fixed assets. A business can charge the full cost of a fixed asset in one accounting period. However, it does not show an accurate cost recovery procedure.
Also, depreciation avoids any compliance issues for a business.
As much as you can recover costs of fixed assets, the yearly accumulating depreciation charge shows accurate account books. Accounting standards provide several guidelines to spread costs of fixed assets. Compliance with these rules means your accounting accuracy is never compromised.
When a business follows accounting and compliance requirements regarding depreciation, it depicts correct account books. It means a business can calculate accurate profits when applying depreciation methods.
Accounting Impact of Depreciation
Depreciation reduces the value of a fixed asset over time. Contrarily, we can say it spreads the total cost of a fixed asset over several years.
Depreciation has some accounting impacts on a business. For instance, a business needs to adjust its cash flow statement to accurately calculate the cashflows. Depreciation is only an accounting entry that does not involve an actual cash flow movement.
On the balance sheet, accumulated depreciation gradually decreases the value of assets. It is in accordance with the natural devaluation of assets over time.
On the income statement, a business records a depreciation expense that reduces its gross profits. It means a business can lower its tax bill with a depreciation expense.
For shareholders and analysts, the depreciation costs can change some key financial ratios. For example, the return on assets and return on equity can change with depreciation costs. The value of fixed assets reduces with accumulated depreciation. That in turn changes these key financial ratios.
In some cases, a business may need to write off or retire a fixed asset. It will require adjustments for the accumulated depreciation and recovery costs. Thus, the accounting treatment for a sudden event such as a write-off will be different from a common depreciation expense.