While there can be something to be said about the simplicity of ignoring depreciation in accounting, it can sometimes be a little short-sighted if we do.
Depreciation. It’s a topic that can easily baffle, or be dismissed as only relevant to businesses seven figure turnovers, owning thousands of assets. While there can be something to be said about the simplicity of ignoring depreciation in accounting, it can sometimes be a little short-sighted if we do.
What exactly is depreciation? It’s a method used to gradually write down the value of expensive items like plant and machinery or motor vehicles over their expected useful life. There are quite a few different methods of depreciation (the way the write down is calculated). The method used could be a company preference, or stipulated by the country/state the business operates in.
Financial Accounting v Tax Accounting: Depreciation in the context being discussed in this blog post is ‘Financial Depreciation’ - how the balance sheet is affected. ‘Tax Depreciation’ is another topic completely. When a tax return is prepared the entire cost of an asset could be offset against profits to reduce tax payable, even though the value of an asset has only reduced by 20% on the balance sheet.
So why do we depreciate an asset even if we can claim the full cost for tax purposes? Let’s say a company has purchased a van for $25,000. If this is treated as a cash cost our financial statements would not reflect the fact that we own a van with any value. Treating the van as a fixed asset will ensure the balance sheet reflects this investment. A year from now it’s likely that the van will be worth less than what we paid for it. So, using our chosen depreciation method, we gradually write down the value of an asset.
How frequently should adjustments for depreciation be made? Traditionally accountants/CPAs have created adjustments between the balance sheet and profit and loss annually when the books are being prepared. The downside is that very often ‘month twelve’ figures are distorted due to a single annual adjusting journal. For general reporting consistency it’s advisable that these kind of adjustments are made each month.
What are the benefits of maintaining an asset register and recording regular depreciation? Firstly, the balance sheet should reflect the true and fair value of assets owned by the company, and the profit and loss should report a consistent monthly charge against depreciation. If you need to report regularly to the bank, or if the business needs to apply for a loan or funding of any kind, accurate financial reporting becomes much more important.
Occasionally, self-employed business owners that are applying for mortgages will need to provide details of financial accounting statements, as well as general tax return information. If there have been significant asset purchases over the last couple of years that have been treated as ‘expenses’ instead of ‘fixed assets’, this could potentially create the difference between reporting a loss instead of a profit. Negative financial reporting could be detrimental to the success of a mortgage application.
Perhaps it’s time to sell an asset or maybe the entire business. Having a record of all assets purchased, and their current net book values held neatly in one place can make life easier when negotiating a sale. In the unfortunate event that a business has suffered from theft or vandalism, flooding or fire damage, the ability to provide an insurance company with a readily available fixed asset register will make life much easier when making a claim.
Fixed assets and Depreciation: Not just for the large corporations; all businesses, large and small.
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