What is Depreciation and How Does It Affect My Accounting?

Introduction

Depreciation is a term used in accounting. The concept of depreciation means that the value of an asset is reduced over time due to normal wear and tear or obsolescence. For example, if you purchase a car for $20,000 and drive it for several years before selling it at auction for $5,000, then the $15,000 difference between what you paid for it and what you sold it for would be considered as the depreciation of that vehicle over its useful life (in this case five years).

What is depreciation?

Depreciation is an accounting concept that comes up when you own or lease assets for your business. Depreciation of an asset is a system of allocating the cost of that asset over its useful life, which results in a reduction in expense and an increase in the carrying value of the asset on your balance sheet. For example, if you buy a computer for $1,000 and it’s expected to last for two years before becoming obsolete, you would depreciate this computer by $500 per year (half its value). This means that at the end of each tax year, you would need to record a decrease in your company’s gross revenue due to depreciation expense (and vice versa) so that there isn't any discrepancy between what comes out from one side versus another.

Depreciation of an asset is a system of allocating the cost of that asset over its useful life, or how long you expect to use it. It is an accounting concept rather than a true cash outflow, so depreciation shows up on your income statement as an expense instead of on your balance sheet. However, it's still important because it reduces your taxable income, which can make a big difference in the amount of money you owe at the end of each year.

How is depreciation calculated?

Depreciation is a concept that has become so common in accounting that it's easy to forget how it works. In essence, depreciation is the process of allocating the cost of a tangible asset over its useful life. It reflects an allocation of cost over time, which means that no cash actually leaves your bank account when you depreciate something.

In other words, depreciation is an accounting concept rather than a true cash outflow—the difference between depreciation and amortization (which we'll talk about later). Depreciation shows up on your income statement as an expense: how much was spent on tangible assets during a certain period?

Depreciation is typically recorded annually by taking the total original cost and subtracting the expected salvage value (or residual value) from that amount and then dividing that number by the number of years you expect to use the asset. For example, if you bought office furniture for $5,000 this year and expect it to last five years with no salvage value at the end of five years, then your annual depreciation expense would be $1,000 and you would record it as $1,000 per year for five years for a total depreciation expense of $5,000. While this straight-line method is one way to calculate depreciation, there are several other types of depreciation methods available too.

How does depression affect my accounting?

Depreciation is very important because it changes the way you record expenses when you buy things. For example, when you buy $100 of supplies, that is expensed in real time and it immediately reduces your business net income. However, when you buy $10,000 of an asset, you cannot immediately recognize a $10,000 expense on your profit and loss statement. Instead, you need to recognize that expense over the course of 3, 5, or even 10 years. So even though you spent $10,000 this year, you only get to recognize $2,000 or $1,000 of an expense this year.

There are special ways that you can depreciate assets in the year you purchased them. You can use things like Section 179 and Bonus Depreciation to recognize the entire expense in the same year. Just be careful when you sell those assets because you might need to recapture some depreciation if you sell the item before its useful life has expired.

Depreciation is incredibly confusing, and I always recommend that you consult with your accounting or tax professional. Click here to contact us today!

Conclusion

I hope this article was helpful in understanding the concept of depreciation and how it can affect your business's bottom line. If you have any questions about how this process works or if there is anything else we can help with, please don't hesitate to contact us!