Assets are reflected on the balance sheet each month in a business. Fixed assets are typically high dollar value assets that remain in the business for at least one year, but up to an indefinite time period (an assets life is usually stated once the purchase has been made). Typically, fixed assets consist of buildings and large equipment and usually represent a very large capital cost. If not accounted for properly, these assets can remain on the balance sheet at the value they are purchased for years while the value of the fixed assets lessens each year the asset is used. Without depreciation, an asset will be overstated on the balance sheet, or in other words, the book value will be much higher than the fair market value. If the business sold an asset at a Fair Market Value of $2,000 but the balance sheet states the asset’s value at $10,000, they would have to record a loss on the sale.
Accounting for the lessening value of an asset is depreciation. Depreciation is a non-cash expense that is taken consistently to lower the value of an asset over a set period of time, otherwise known as “the asset’s useful life”. There are multiple ways to account for deprecation – the most common is straight line. Straight line depreciation is calculated by taking the total cost of an asset divided by the periods it will be used (years, months, quarters, etc.). By spreading out the depreciation, a business recognizes a steady monthly expense for using the asset. If the value of an asset is steadily decreasing over time, a business has the ability to asses its declining value, and therefore can better plan when an asset will be obsolete and/or need replacement. This allows business owners to make better business decisions and prepare for future growth. Businesses should set a threshold that will be the standard for all assets that are to be depreciated. A typical threshold is $1,000. A threshold such as this determines that any equipment or furniture purchased at an amount over $1,000 will be placed on the balance sheet and will be depreciated over its useful life. A standard documented threshold creates consistency in reporting for a business and should be determined immediately if not already in place.
Depreciation is a valuable tool businesses use to recognize expenses for large purchases over their useful life. To maximize its value, accounting professionals, like TGG Accounting, can help explain, strategize, and record depreciation in your business. As year-end approaches, do not miss out on using this valuable accounting principle.Written by: Andrea Steinbrenner TGG Accounting