Depreciation

Depreciation is the accounting method of allocating the cost of an asset over its useful life. Most fixed assets, with the exception of land that buildings are on, are depreciable assets.

Accountants like to count expenses against the revenue for the same period. So, if you billed for $100,000 worth of work in a month, and had expenses associated with delivering that work of $85,000 that month, you can figure what your profit was. 

But what messes them up is when you buy something that lasts a long time, like a vehicle, or a new computer system. It’s an expense, yes, but the benefit will last a long time – let’s say 5 years (60 months). So the accountant will take 1/60th of the expense of the vehicle each month for 5 years. That’s called depreciation.

So this is how it works. When you buy that vehicle, it will not show on your Income Statement (P&L) for the month. Instead, it goes on the Balance Sheet as an asset for the full value of what you paid for it. If you took out a loan to buy the vehicle, the amount of the loan goes on your Balance Sheet as a liability.

Each month, your accountant will subtract 1/60th of the value from the asset section of the Balance Sheet, not by reducing the value of the asset, but by creating a line called “Accumulated Depreciation,” which would be a (negative number) under the value of your assets. 

So let’s say the vehicle cost $60,000. Each month your accountant will depreciate $1,000 of the truck. So after 10 months, the Balance Sheet shows $60,000 for the value of the truck, and ($10,000) of accumulated depreciation, with a net value of $50,000. You see, the truck is older now and not worth as much. Of course, it doesn’t show a line item for each asset you are depreciating – it just shows the value of all the accumulated depreciation you have taken on all assets listed. 

Let’s say you own the vehicle for 6 years and depreciated it over five years. After 60 months it is fully depreciated. What does that mean? It means the value of the asset will show on your Balance Sheet as $60,000 (the price you paid for it 6 years ago) and the Balance Sheet will also show $60,000 of “Accumulated Depreciation” as a negative number in your asset column – effectively making the value of the asset on your Balance Sheet zero. 

The truck stays on your Balance Sheet that way forever until you sell it or get rid of it. Let’s say you junk the vehicle in year 8. You remove $60,000 worth of assets and $60,000 of accumulated depreciation from your Balance Sheet.

That’s what is happening on the Balance Sheet. 

On the monthly Income Statement, the expense for the truck never showed in the month you bought it. Instead, your accountant will add a $1,000 expense each month for “depreciation” of that truck. In other words, you “used up” 1/60th of that truck that month, so we are taking an expense for it that month.

Different assets are depreciated for different periods of time. Buildings (not the land they are on): 39 years. Computers and trucks: 5 years. Equipment and Machinery: 5, 7 or 10 years. Furniture, 5-7 years. If I remodel my office or re-roof my building: 7, 10 or 15 years depending on how long these things are expected to last.

It’s important to note that depreciation for accounting purposes is different than depreciation for tax purposes. Tax law may allow you to expense fixed assets faster or all in the same year. Consult your tax professional.

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