It is a rule of thumb that, once you drive a brand new car off the dealership lot, its value falls by 25%. This means that, should you choose to sell the car back to the dealership or car company within 30 minutes of buying it, you would only get back 75% of what you spent on it. This fall in value is referred to as ‘depreciation’. Now, this is a rather extreme example of this phenomenon, but it illustrates an unavoidable fact of life for individuals as well as businesses both large and small. At a personal level, accounting for depreciation as demonstrated in the example above, it is readily apparent how depreciation affects individual people. In this post, we explore why it matters to small businesses and what SMBs need to consider when it comes to financially accounting for depreciation.
What is depreciation and why is it important?
Depreciation in business refers to the fall in value over time, of a company’s fixed assets. Fixed assets include buildings, machinery, and electronic items like computers and printers. Depreciation is an important aspect of a business’ finances as this gradual decline in the value of fixed assets is something that companies can use to their advantage when it comes to planning for, and doing, their taxes. Since 1999-2000, Indian tax law has allowed companies to claim and write off depreciation costs thereby reducing their tax liability (the amount of tax money they are liable to pay the government).
So in accounting terms, depreciation is the process of quantifying the fall in a fixed asset’s value and then treating it as a business expense or cost.
Three key factors
There are three important factors that define the depreciation process: Useful Life, Salvage Value, and Obsolescence.
Useful Life: Refers to the length of time during which an asset has been functional and ‘of use’ to a company.
Salvage Value: Is the amount of money that a company can expect to get (‘salvage’) from selling a product during or at the end of its useful life.
Obsolescence: Literally means ‘uselessness’. Obviously, from a deprecation perspective, this refers to an assessment of how long an asset can be utilised, in order to determine if it has reached the end of its useful life.
When applying the parameters listed above to calculate depreciation, it is the asset’s cost at the time of its purchase that is used, and not its current market value. This is imperative when calculating the accounting for depreciation of the business.
Something else that is important to keep in mind is the fact that not all fixed assets can be counted as depreciable. For example, an asset that was bought just one year ago is unlikely to be considered eligible (nor is the car that one drives off the parking lot for that matter.)
It is also worth noting that an SMB can only claim depreciation expenses for assets that it owns, and not for assets that it is leasing.
Formula: The formula by which to calculate depreciation is as follows.
Depreciation = (Purchase Price of the asset)-(Salvage Value)/Useful Life
Depreciation is an important tool in a company’s financial arsenal and must be used in order to reap tax benefits. This is why companies should sit down with their accountants before and after purchasing fixed assets so as to properly exploit this important tax loophole.