Why Depreciation is Essential in Accounting
Depreciation is a way to account for changes in the value of an asset. (An asset is something that has continuing value, like a computer, a car, or a piece of machinery.) It represents the decrease in the value of an asset over time. It’s expressed in both the balance sheet and income statement of a business. Depreciation also affects your business taxes and is included on tax statements. Depreciation is necessary because if you didn’t have it, you would not correctly show the expense of owning an asset. Here’s the issue:
If you buy the services of a CPA to do your business tax return, you deduct the expense in the year you buy it. But you also use the expense in that year. If you buy a car for business use, you use it over several years, so the expense should be spread out over the years you use it.
How Depreciation Works
Let’s say you buy a business asset (like a car for business use), for $20,000. You’ve heard that the car depreciates as soon as it’s driven off the lot; this is how it works. When you sell it a few years later, you find that you can only get $12,000 for it. The $8,000 you lost is depreciation. It’s an expense of doing business. In this article, we’re only going to look at the asset itself and the depreciation, and how they work for your business accounting statements - your balance sheet and profit and loss statement - and for your business tax returns.
Depreciation on Your Balance Sheet
The balance sheet of a business shows the value of the assets of the business against the value of the liabilities and owner’s equity or retained earnings. Depreciation is included in the asset side of the balance sheet to show the decrease in value of capital assets at one point in time. It is expressed as “accumulated depreciation,” or the total loss in value from the acquisition of the asset to the present time, leaving the book value as the remaining value of the asset. On the balance sheet, it looks like this:
Cost of assetsLess Accumulated DepreciationEquals Book Value of Assets
Here is an example that could be found on a balance sheet, as of December 31, 2020:
Office Equipment $129,000Less Accumulated Depreciation- Office Equipment $100,000Book Value - Office Equipment $29,000
Showing depreciation in this way allows the reader to see the full value of the assets and the decrease in value, with the resulting book value.
Depreciation on the Income Statement (P&L Statement)
On the income statement, the amount of depreciation expensed or taken during the time period in question is shown along with other expenses of the business. The expense for the time (usually a year) is added to the previous depreciation expense to equal accumulated depreciation. Using the example above, the depreciation expense for 2020 on Office Equipment might be $12,000, which would show as an expense on the Income Statement. Thus, at the end of 2020, Office Equipment might look like this on the Balance Sheet:
Office Equipment $129,000Less Accumulated Depreciation- Office Equipment $112,000Book Value - Office Equipment $17,000
Depreciation in Your Business Tax Documents
Depreciation for the tax year, for all depreciated assets, is included on your business tax return as a business expense. Each type of business tax form has an expense line for depreciation. In some circumstances, you will also have to complete an extra form, IRS Form 4562 - Depreciation and Amortization to verify the total depreciation expense shown on your business tax return. This tax form totals all depreciated assets. It is a complex form and requires a tax professional to complete.
