That point in time when someone realises what depreciation is, and how it can work for their business, can be a sublime moment.
What is depreciation?
In our workshops, we often delight in that sublime moment when the participants realise that depreciation is actually a very simple concept.
Depreciation is an expense and represents the wearing out of the physical non-current (fixed) assets such as buildings, plant and equipment, vehicles, furniture and the like.
In simple terms, you pay $X to acquire the asset and then as that asset is used in the business it begins to lose value over time. It is that loss of value each year that becomes the depreciation expense for that year.
When you acquire a physical asset that will wear out through use, you initially determine the most appropriate method of depreciation to best reflect the pattern of wear and tear. You can use the depreciation schedules produced by the tax office (check its website) or your own estimations if you believe these to be more accurate than those provided by the tax office (note however that generally you will still have to convert to the tax office ones in your income tax return).
There are many methods of depreciation. A simple time basis will work well for many assets – “this asset is expected to last 10 years and will wear out evenly over that time so I will depreciate one-tenth of its value (less its estimated disposal value) each year”.
For others a production basis such as machine hours, or units produced, will be more appropriate. Complex or unique assets such as boilers, smelters or submarines (!) will require an expert’s assistance.
Depreciation is often referred to as a non-cash expense. When you acquire the asset, the cash usually changes hands up-front. Then each year the asset value is reduced by the depreciation amount charged to that asset – the value of your business assets decrease and that loss of value is recorded as an expense. No cash changes hands – that’s already happened. Being an expense, depreciation reduces the profit, and therefore the net worth (equity), of the organisation.
Sometimes people think that depreciation is also a mechanism to save up and replace the asset – it isn’t. Saving up for the replacement asset requires you to set aside some cash each year, just like saving up for anything. You could set cash aside to match the amount of depreciation charged each year – but remember that the concepts are different. Funding of your business assets is usually a key strategic decision and that is no different for your fixed assets.
- It’s a bit too easy to “set and forget” your fixed assets. They can soak up a lot of funds and need to earn their keep just like all your assets.
- Depreciation is an estimation that is precisely why many analysts remove it from their calculations (for example, earnings before interest, tax, Ddepreciation and amortisation – EBITDA). Try and be as accurate and consistent as you can. Use experts if necessary.
- A properly maintained fixed asset register can streamline much of the work involved in recording and maintaining your fixed assets.
Do you like to win? We are holding a one-day public “Accounting Mastery” workshop in Melbourne CBD on Friday, 2nd of November. We have some spare seats and so would like to offer one lucky SmartCompany reader the opportunity to win a place at this workshop, valued at $700. All you have to do is email me via comments below a short statement as to why you should win the spot.
Mark Robilliard and business partners Peter Frampton and Carmen Mettler started a journey to find a new way for anyone to ‘get accounting’ and use it in their job and life to create value. Accounting Comes Alive was born and now provides workshops all over the world using their unique Colour Accounting™ learning system that really does work, for anyone.
To read more Mark Robilliard blogs, click here.
Mark Harbottle at Sitepoint writes: How about this? I will donate $500 to a charity of your choosing if I win the ticket. If I absolutely love the course, I will donate the full $700.