Importance of Depreciation in Tracking Fixed Assets
You finally feel like you've got the hang of tracking your assets. All of your employees are on the same page and know how to update your database. Your fixed asset depreciation software is configured to fit your needs, and things are running smoothly.
But there may be something you missed that could bring your business thousands in tax savings. As a business, you shouldn't overlook the importance of depreciation as it relates to your assets.
What is the importance of depreciation of fixed assets?
Asset depreciation allows businesses to use a tax write-off to pay for fixed assets over time. This depreciation of fixed assets in both taxes and accounting can be applied to the cost of buildings, vehicles, equipment, furniture, machines, and even software.
This process doesn't create a source of revenue. Rather, it is a process that allows a company to see the use of an asset's value over time and use that information to report actual asset expenses compared to just the cost of purchasing the asset.
There are three important factors when calculating depreciation:
- Useful life: The amount of time a company expects an asset to be productive. Depreciation is calculated during this time period.
- Salvage value: When a business gets rid of an asset, it could sell it for a reduced amount. This amount is called the salvage value. Overall depreciation is figured out by subtracting the salvage value from the asset cost.
- Depreciation method: There are two main methods of calculating. The first is the straight-line method, which takes the overall depreciation and divides it evenly over the useful life of the asset. The second is the Accelerated Method, which creates more depreciation early on in the life of a fixed asset. The Straight Line Method makes for easy calculation, while the Accelerated Method defers a portion of income tax.
For example, if you were to buy some equipment for $20,000, you have one of two choices. Either you could write off the cost of the asset that year, or you could write off its value over an expected lifetime of 10 years.
If the expected salvage cost is $2,000, your expected depreciation cost would be $1,800 yearly.
The benefits of asset depreciation
How can this complicated process benefit your business? Is it worth the hassle of adding depreciation values to your accounting process each year?
Because depreciation can lead to tax savings and allocating funds to future asset acquirement, the importance of depreciation is worth some consideration.
Depreciation has multiple benefits:
- The process helps companies accurately state incurred expenses from using the asset and compare that to the revenue that the asset brings in. Lack of depreciation can lead to overstating or understating total asset expenses, which can lead to misleading financial information.
- It also helps businesses report the correct net book value of a given asset. Most businesses report the original purchase cost of the asset. But, since assets experience wear and tear from daily use, the actual value declines over time. Companies can find an asset's net book value by subtracting the asset's overall depreciation expense from the cost when the asset was purchased.
- Depreciation allows companies to recover the cost of an asset when it was purchased. The process enables companies to cover the total cost of an asset over its lifespan instead of immediately recovering the purchase cost. Tracking depreciation allows companies to replace future assets using the appropriate amount of revenue.
- There are tax rules that make depreciation tax deductible. A greater depreciation expense lowers taxable income and increases tax savings.
To accurately report an asset's depreciation, you have to keep a copy of your invoice for proof of payment. You also need to prove that you paid the appropriate sales tax for your state. Depreciation is calculated at the end of the year so that it can be included in your taxes.
But not all items are worth depreciating. Items that cost little or will last up to a few months are not subject to this process. Land and personal items used outside of business are also not subject to depreciation. However, items like cars or computers that are used for both personal and business purposes can be partially depreciated.
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