Depreciation has two purposes. It is the way that the cost of a fixed asset investment is recorded on the Earnings Statement as a business expense and it provides a mechanism to determine a fixed asset value after it has been in service for several years.
When to Use Depreciation
If you capitalize a fixed asset, you are required to depreciate it on the business financial books.
The concept of depreciation is very simple. The acquisition value of the fixed asset is allocated over a number of years that normally represents the useful life of the asset.
- The allocation of the value to multiple years (sometimes it is even further sub-allocated by quarter or month) is known as the depreciation schedule.
- There are many different ways to allocate the value; finance will tell you which method to use based upon the asset type.
- Once a depreciation schedule is established for a fixed asset, it is not changed until the depreciation is complete or the asset is disposed of.
- If you dispose of an asset before the depreciation schedule is complete, all remaining depreciation must be recorded at the time of disposal.
- To start depreciating, you must know the value of the asset, the life in years over which the asset will be depreciated, the remaining residual value of the asset (normally $0) and the depreciation schedule that is to be used.
- The amount of depreciation for a given year is recorded on the Earnings Statement as part of the fixed cost in the operations expense category.
- Although it is in the operations expense category on the Earnings Statement, it is not part of OpEx. The depreciation amount is still referred to as CapEx since it is the charge for a capital fixed asset.
- Because the depreciation for a given year is in the Earnings Statement for that year, the Net Income is reduced by the amount of the depreciation. However, since the value of the acquisition of the fixed asset was already recorded in the Cash Flow Statement as a Cash for Investment Activities at the time of the asset acquisition, the deprecation costs must be reversed in the Cash Flow from Operating Activities since that section starts with the Net Income for the given year.
- The value of the fixed asset is shown on the Balance Sheet as the original acquisition value less any accumulated depreciation. This is also referred to as the Book Value.
Hints and Tips
- The amount of depreciation can impact the amount of income tax due since it affects the Net Income and it will impact property tax due since property tax is calculated based upon the value of the asset. Therefore taxing agencies pay very close attention to depreciation and that means that the Finance department will also pay close attention.
- Once an asset goes into service, the depreciation must start and it cannot stop, even if you stop using the asset. The only way to stop the depreciation is to dispose of the asset.
- An asset can be fully depreciated and be on the books showing a “$0” asset value yet still providing value to the company. This is often the case with equipment that has been in service for a long time.
- If you dispose of an asset and receive more than its book value, you must show that as a capital gain on the Earning Statement; if you receive less than the book value you may show it as a capital loss on the Earnings Statement.
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