The Importance of Fixed Asset Depreciation

March 17, 2022

The Importance of Fixed Asset Depreciation

Fixed assets are an investment in the future of your business. Buying a building gives you a place to run your operations that appreciates in value. You can use furniture, equipment, and vehicles in your operations to generate income. And they can all be converted to cash when necessary.

But there’s another advantage to investing in fixed assets that many business owners overlook: fixed asset depreciation.

What is fixed asset depreciation?

Depreciation is an accounting principle that says if an asset is used over multiple accounting periods, the cost of that asset should be spread over multiple periods in your accounting records. In other words, instead of writing off the cost of something expensive you purchased for the business in the year you bought it, you write off a portion of the cost each year of its estimated useful life.

Which assets should I depreciate?

There are two questions to help you decide whether you should capitalize an asset (i.e., add it to your balance sheet) and depreciate it or deduct it as a normal expense.

1. Will the asset last over multiple accounting periods?

Things like buildings, furniture and fixtures, equipment, vehicles, and computers provide value over several years. These are likely to be depreciated. Things that may be consumed within an accounting period, such as office supplies, should be expensed.

2. How much does the asset cost?

A larger purchase, like a £7,518.87 piece of equipment or a £22,607.85 delivery van, most likely has a significant impact on your financial statements and should be depreciated. Some other purchases — for example, a £15 garbage can for your office — may be used for several years, but it’s inexpensive enough that it’s not worth the hassle of capitalizing and depreciating.

How is depreciation calculated?

While there are many depreciation methods, they generally fall into two main categories: book depreciation and tax depreciation.

Book depreciation

Book depreciation is the method you use for your business’s books and records. The goal is to match an asset’s cost with the income that asset helps you generate across its lifetime.

Straight-line depreciation is the most common method for depreciating property for book purposes. With the straight-line method, you take the total cost of the asset and divide it by its useful life. The result is the amount you’ll book with a depreciation expense journal entry each year until you’ve written off the asset’s full cost.

For example, say you pay £1,507 for a computer you expect to use for five years. Using straight-line depreciation, you would record depreciation expense of £301 per year (£1,507/ 5 years).

Tax depreciation

Tax depreciation also matches the asset’s cost to the amount of time you’ll use the asset in your business. For tax purposes, most assets are depreciated using the Modified Accelerated Cost Recovery System (MACRS). MACRS allows you to write off more costs in the early years of the asset’s life. However, the asset's useful life is determined by the property class.

IRS Publication 946 details on property classes and how to calculate MACRS depreciation. However, calculating MACRS is much more complicated than straight-line depreciation, so most businesses leave it to their accounting software or an accounting professional.

Why is fixed asset depreciation important?

Depreciating your company’s fixed assets service three main purposes.

1. Depreciation helps you understand the real cost of doing business

One of the basic principles of accrual accounting is the matching principle, which requires companies to report expenses in the same accounting period as the revenues they help generate.

In other words, when a company purchases an asset that is expected to generate benefits across several accounting periods, the cost of that asset shouldn’t be written off in the year it’s acquired.

For example, say you want to purchase an expensive piece of equipment for your business that will help you generate additional revenues over the next seven years. Writing off the full cost of that equipment in year one — and not accounting for any of those costs in the next six years — would greatly distort your financial statements. Your net income would be understated in the year you paid for the equipment and overstated in the following years.

Depreciating fixed assets ensures your financial statements present a more accurate picture of your company’s costs and results of operations.

2. Depreciation provides tax benefits

Because depreciation lowers your profit, it can also reduce the amount of tax you owe. If you don’t claim depreciation, you will end up paying too much tax.

In fact, the Tax Code provides businesses with extra incentives to invest in fixed assets:

  • Section 179. Internal Revenue Code (IRC) Section 179 allows businesses to expense the full purchase price of qualifying equipment and computer software placed in service during the tax year.
  • Bonus depreciation. Bonus depreciation allows businesses to depreciate 100% of the cost of qualifying business property in the year it’s purchased.

IRS Publication provides more details on the rules and limits for writing off fixed assets using Section 179 and bonus depreciation.

3. Depreciation helps value your business

Most fixed assets lose value over time. For example, a manufacturing company with old equipment may not be worth as much as a company with new equipment. Deprecation allows you to present an accurate picture of the value of your business on the balance sheet by showing your assets’ net book value — the original purchase cost less accumulated depreciation.

Depreciation may seem tricky at first, but it’s worth the effort. It helps you present a more accurate picture of your company’s assets and results of operations in your financial statements and benefit from valuable tax deductions. If you need help, be sure to reach out to your accountant. They can help you track and depreciate fixed assets in a way that enables business growth rather than hindering progress.

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