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  • Understanding Depreciation

    Game Plan

    In-Depth

    Depreciation Defined

    Depreciation is a non-cash business expense that is allocated and calculated over the period that an asset is useful to your business. Every business can take advantage of depreciation by deducting the expense of using up a portion of the value of an asset from taxable income. That result is tax savings.

    Depreciation is an artifact of GAAP (generally accepted accounting principles). When you invest in certain types of property for your business, even though you may use cash to make the purchase, you typically can’t immediately deduct the entire cost as expense against revenue. That’s because of GAAP’s matching principle, which sets out that expenses should be recorded in the same period in which revenue is earned from them.

    How you make use of depreciation depends on what your business requires. These are some of the key ways depreciation is used:

    Tax Deductions
    As mentioned above, depreciation will help you generate savings on your tax return. IRS rules change frequently, so you’ll probably want to work with an accountant in fine-tuning how you treat depreciation for tax purposes. But certainly one tactic might be to use an accelerated depreciation method [link to “reducing-balance method” section within this Playbook module] in years that you acquire depreciable assets and anticipate higher revenues, to achieve a more manageable tax bill.

    Matching Expenses to Balance Your Books
    This matching principle matters to accountants, investors in your business and, potentially, auditors—but it should also matter to you. Simply put, depreciation, when executed properly, enables you to match your expenses to revenues, and come up with an accurate picture of your true business expenses over a specific accounting period.

    Accurately Valuing Assets
    Depreciation helps you arrive at a realistic number for the value of your company’s assets. Public companies need this valuation to correctly declare the net book value of assets in reports to shareholders. If you’re looking to secure a loan for your business, you’ll probably need an accurate valuation as well. But it’s also useful information for your business planning purposes. As an asset’s useful life wanes, you’ll need to set aside funds for its eventual replacement.

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    Game Plan

    • Your accountant or tax preparer is probably your best resource for helping you take advantage of the depreciation expense on your company’s balance sheet.
    • If you use a software program that automates your major bookkeeping functions, it may include a depreciation calculation function. If yours doesn’t, Google “depreciation calculation software”—a number of free downloads is available.