Things like trucks, computers, desks, warehouses, and machinery all have lifespans. These tangible assets are all bought to serve a business purpose, and as they age, the less effective they are at what they do and the less value they have.
Businesses record this loss of value as depreciation, and there are many ways to measure and record it, according to GAAP and tax purposes. Depreciation refers to an accurate representation of an asset’s loss of value over time. Depreciation stops when the asset is taken out of service or when its “book value” reaches zero.
While the process of depreciating assets is complicated and in many cases should be something left to a professional, it accomplishes three important functions:
- Measure and record an expense – Depreciation helps you figure out how much value your assets lost over the year. It is different from other expenses as it is an estimate of value lost from a balance sheet item. While no cash is spent, value is lost and therefore must be subtracted from revenue when calculating profit.
- Lower your tax bill – As with many expenses, depreciation qualifies as a deduction. What makes depreciation different and more complicated is it is a deduction you can take for the same asset over multiple tax years.
- Valuing your business – As your assets lose value, so does your business. Fixed assets are listed on the balance sheet, and the value of each of those assets is reduced by a contra account called “accumulated depreciation.”