Which category does depreciation fall under, and why is it important for your business accounting?

The Importance of Understanding Depreciation in Budgeting

Accountants and business executives need to understand which category depreciation falls under in the company’s annual budget, as it is one of the key factors affecting net profit calculations and the financial position of the company. Depreciation is the process of reducing the value of business assets over time, which involves allocating the initial cost of expensive assets across their expected useful life.

When a company invests in fixed assets such as machinery or vehicles, depreciation is calculated based on the number of years the asset is expected to be usable. For example, if a company purchases a computer expected to last about 5 years, depreciation will be divided over that 5-year period.

Where does depreciation appear in the accounting statements?

Depreciation is included in the calculation of EBIT (Earnings Before Interest and Taxes), which shows how much income your business generates before interest and taxes are deducted. Including depreciation in EBIT is important because it indicates that companies with many fixed assets will have lower EBIT compared to companies with fewer fixed assets.

A key difference is EBITDA, which stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. EBITDA adds back depreciation and amortization to the EBIT figure, making EBITDA always higher than EBIT. Investors often use EBITDA to compare companies across industries with different asset structures.

Which assets can be depreciated?

Assets can be depreciated if they have the following characteristics:

• They are owned by the company and used to generate income
• They have a clearly defined useful life
• They are expected to be usable for more than one year

Assets eligible for depreciation include vehicles, buildings, office equipment, furniture, machinery, and electronic devices. It also includes certain intangible assets such as patents, copyrights, and computer software.

Assets that depreciation falls under but cannot be depreciated include land, collectibles, investments, and personal property, as these assets do not deteriorate or their value changes irregularly.

Common methods for calculating depreciation

Straight-line Method (

This is the simplest and most popular method, dividing the asset’s value evenly over its useful life. The advantage is easy calculation and consistent annual depreciation amounts. However, the disadvantage is that it does not account for faster loss of value in the early years of use.

) Double-declining Balance ###

This method allows for higher depreciation expenses in the early years when the asset is new. The benefit is maximizing tax benefits in the initial period. However, it is more complex to calculate and may not be suitable for small businesses.

( Declining Balance )

An accelerated depreciation method that calculates depreciation at twice the rate of the straight-line method. This results in higher depreciation in the first year and decreasing amounts in subsequent years.

Units of Production (

This method calculates depreciation based on actual usage, such as hours of operation or units produced. The advantage is precise depreciation aligned with actual usage, but tracking usage can be cumbersome.

What is amortization )?

Amortization is a process similar to depreciation but applied to intangible assets such as patents, copyrights, and loans, where the asset’s value decreases over a specified period.

Amortization also refers to the regular repayment of a loan, where each installment includes interest and principal. For example, with a car loan, most of the repayment initially goes toward the principal, but over time, the interest portion decreases while the principal repayment increases.

The difference between depreciation and amortization

Depreciation applies to tangible assets like buildings and machinery, while amortization applies to intangible assets like copyrights and patents.

Depreciation can be calculated using various methods, such as straight-line or accelerated methods, whereas amortization typically uses only the straight-line method. This explains why intangible assets tend to decrease in value steadily over their useful life.

Summary

Understanding which category depreciation falls under and applying the correct calculation method are crucial for financial analysis. Whether you are an investor, executive, or accountant, knowledge of depreciation and amortization helps you gain a deeper understanding of a company’s true financial position, as well as aiding in investment decisions and future business planning.