Depreciation: An Overview

All assets, except for land, eventually wear out. Even your warehouse, which may stand for more than a hundred years, will one day fall under the wrecker's ball because it is too old and decrepit to have use to your business.

Depreciation is the process of allocating the cost of the asset slowly into expense over the useful life of that asset. It makes intuitive sense that you should be allowed an expense for the decline in usefulness of an asset as it ages. However, it's important not to confuse the concept of depreciation with market value. Market value has no bearing on the financial statements, which in most cases report historical cost.

To facilitate the depreciation of assets, you need to group them according to their expected useful lives. A building has a much longer useful life than a computer has. Each grouping of capital assets will have its own depreciation method and rate. The common groupings are as follows:

Land

This grouping is self-explanatory. It is the land owned by the company that is used in the production of income. Land under the warehouse and plant would be included, but land bought in cottage country for speculation would not. Land always goes into a category by itself because it is the only asset that does not decline in value over time and thus is not depreciated.

Buildings

This grouping includes all buildings belonging to the company, but not the land they sit on (see above). All major renovations and improvements to the buildings over the years would be included in this account as well.

Equipment

All of the machinery and other productive equipment go into this grouping. Office equipment has its own category.

Tools

Generally, tools that cost more than $200 go in this category. Anything under that limit gets expensed on the income statement as small tools.

Office equipment

Fax machines, photocopiers, binding machines, and the like belong here. Computer equipment is placed in a separate category.

Signage

All signs made for the business (again, costing more than $200) should be capitalized into this account because the signs have a useful life extending over several years. The majority of small business bookkeepers mistakenly expense these costs into advertising and promotion.

Computer hardware

This category encompasses all computer components except for software. It includes monitors, hard drives, CPUS, mouses (or mice, depending on your preference), and keyboards.

Computer software

This category includes the programs that you buy for your computer: accounting, CAD, spreadsheet, and e-mail programs. Computer software is in a separate category from hardware because it is generally recognized that it becomes obsolete faster than hardware.

Vehicles

This includes trucks, trailers, passenger vehicles, ATVS, and other motorized vehicles that the company owns.

Now that you know how to categorize your capital assets, you need to look at the concepts involved in depreciation as well as the various methods of depreciation. Don't worry: it's not hard. Grab another coffee, and let's go!