If your new to business and don’t understand what depreciation is exactly, then briefly; Depreciation is a reduction in value of an asset over time usually caused to wear and tear. We understand how boring it might sound but stay with me; the main reasons a business should depreciate assets is so that the correct valuation is given according to their worth in the accounting books, which ensures an accurate representation of the company. It is important to understand the worth of your company for many reasons but mainly so that you can accurately track growth, in order to see where it has come and where it is going. Depreciation is one of many aspects that need to be considered and should only be done to fixed assets though, which means property, plant and equipment (PP&E) and not done to inventory.
Fixed assets or PP&E involve but are not limited to, machinery, technology, vehicles and buildings. The assets that are vital to the business but cannot be easily liquidated. On the circumstances that particular businesses sell products like cars or computers, then they are not considered assets, they are the inventory the company purchases to then sell. Essentially it is what your business ‘uses’ but does not ‘Sell.’
In order to fully understand all the elements involved in correctly depreciating your equipment, let’s say that your business purchased a computer for $2000, and now let’s say that its useful life was estimated at 4 years and the salvage cost (how much it is worth after four years to sell) is $200. Salvage cost is deducted off the total purchase price to show worth after full depreciation and can equal $0. This means that every year, depreciation for the computer would be $450, considering a straight line depreciation method. This is up until the end of the fourth year where depreciation would then equal $0. For the sake of the example, let’s say the computer was still working up to standard at the end of the four years. On accounting balance sheets, after the asset has fully depreciated it is effectively shown as $200 within (PP&E) because of how much it is still worth if it is sold. The object is never taken off the balance sheet while it remains part of the business, unless the business sells it.
Depreciation is just a rough estimate on how long the useful life of a product is; these estimates have to be done though in accordance to the ‘Internal revenue service’ (IRS) rules. The Australian tax office (ATO) has an online calculator to assist in determining the depreciation of assets. Decline in value calculator
Okay so Why Do I Care about Depreciation?
For your small or starter business, having organised and accurate calculations of company worth will allow you to understand development and specific areas of growth or potential threats which will only benefit managerial decisions. Potential managerial decisions that when considering the financial future of the business, will ultimately determine whether the company succeeds or thrives. But please don’t understand from this that depreciation is the ultimate account tool that determines all avenues of the finance sector, Depreciation is mealy a small cog in the machine of your business accounts that inevitably contributes to majority of daily decisions.