Simply put, depreciation is both the fact that an item (an asset) loses value over time and the way to expense the cost of that item. If you’re familiar with the concept, you know that an asset is an item – a piece of machinery, equipment, furniture, etc. – that you purchase for your business that you expect to have and use for substantially more than one year. (If you’re not familiar with the concept, you can read my earlier post on capitalizing assets.) For accounting purposes, assets are then depreciated over time until they are fully expensed and no longer have value.
USUAL HANDLING OF DEPRECIATION
Generally accepted accounting principles (GAAP) dictate that all long-lived assets purchased by a company be capitalized and depreciated. Long-lived assets are items that provide a company with economic benefit beyond the current operating period. Once purchased, the cost of a long-lived asset is then depreciated (meaning expensed) over the estimated useful life of the asset. This is done in order to match the cost of the asset with the full period of time that your company is going to benefit from it instead of lumping it into one accounting period. In addition, the process of depreciating helps to smooth out the net income fluctuation that would otherwise occur if you expensed larger dollar items in the period in which they were purchased.
But if you’re operating a small business and your main focus in on your operating profit or loss each month, do you really need to worry about tracking depreciation? If your business is preparing GAAP financial statements for users outside of the organization, then the answer is definitely yes. But if your business isn’t, then I say, don’t bother.
NEW THINKING
After many years of recording monthly depreciation on the books for my clients, I am now advocating that it’s not necessary for a small business to cloud its income statement with depreciation expense – or amortization expense for that matter. As the business owner, what you’re really interested in is what was the company’s operating profit or loss at the end of each month. Depreciation is a non-cash expense and therefore, not really relevant to your monthly operating activities.
However, because the IRS requires businesses to capitalize and depreciate long-lived assets for tax purposes, you will still need to track the purchase of these types of assets separately; but leave the calculation of depreciation to your tax accountant at year end.
I would suggest that you create a separate expense account and call it “Assets Purchased” or maybe “Long-Lived Assets Purchased” and use that account to expense your purchases. With a separate account, the money that you spend will be reflected in your profit and loss and your tax accountant will easily be able to see what new assets you purchased that year.
In addition, you should have another account called “Small Tools and Equipment” or something similar for purchases of small, inexpensive (less than $200) hand tools or other items. Yes, these items may have a useful life of more than one year (e.g. a drill bit, calculator, wrench or file cabinet) but their cost and thus their value after one year is so small as to eliminate the need for depreciation.
FINANCING ASSET PURCHASES
I am also advocating a change from how GAAP normally accounts for loan payments. When a business borrows money to purchase a long-lived asset, it books the item as a fixed asset and the corresponding loan as a liability. Loan payments are then posted against the liability account to reduce its balance. Posting a payment to a liability account does not affect the income statement.
But if you create an expense account for the loan payment and post your payment to the expense account each month instead of to the liability account, it will appear in your income statement and you’ll be able to see the expense of those monthly payments.
At tax time, your accountant will easily be able to identify your loan payments and can make the necessary adjustments to complete your tax return.
MAKE IT EASY ON YOURSELF
If you’re a small business owner handling the books yourself or with the assistance of a bookkeeper, knowing what to depreciate, what method of depreciation to use and then how to book the transactions can be difficult and time consuming. Simplify your accounting and leave the depreciation for your tax accountant.
I encourage you to post comments or questions if you have them. Thanks.