The Advantages of Depreciation on Equipment

Companies carry out depreciation on equipment used in business operations based on certain accounting standards and tax rules. Depreciation is the annual cost allocation of an equipment's purchase value over the equipment's service life. Depreciation is necessary in financial reporting to ensure that the amount of business profit the equipment helps generate and the value of the equipment as an asset are appropriately stated. Companies also use depreciation for tax purposes and as a way of equipment cost recovery.

True Profit

When a piece of equipment is placed in service for business operations, the use of the equipment not only helps generate sales revenue but also represents a form of operating expense. Companies pay a total sum in advance when purchasing the equipment, but they can only allocate the total cost over time through equipment depreciation. Thus, depreciation is the cost of using the equipment. Without taking consideration of equipment depreciation, companies will understate operating expenses and overstate their profit.

Fair Asset Value

Companies initially report the value of a piece of equipment as a capital asset on the balance sheet at its original purchase cost. However, over time, the value of the equipment decreases as it endures wear and tear from operational uses and becomes obsolete in functionality as new technologies come to markets. Thus, depreciation on equipment as a form of operating expense is effectively deductions to the equipment's original purchase value. Accounting standards require that companies report their assets at fair market value on statement dates, and depreciation on equipment can serve as a contra balance to the equipment's original value to reflect the true carrying value of the equipment at the time.

Tax Savings

One major advantage of depreciation on equipment is the tax savings for companies. Depreciation on equipment as an operating expense is an allowable tax deduction under tax rules even though it is not actual cash outflows. On an annual basis, the higher depreciation a company charges, the more it can subtract from its taxable income and, thus, the more tax savings it can achieve. Given a company's tax rate, tax savings can be calculated directly by multiplying the tax rate by the amount of depreciation.

Cost Recovery

Companies also use depreciation to recover the equipment's original purchase cost. As the old equipment expires in its useful life and is taken out of service, companies need to purchase new equipment as replacements. To help accumulate funds for new equipment purchases, companies use depreciation to set aside a portion of the revenue in the amount of annual depreciation expense. At the end of the equipment's service life, the accumulated depreciation would equal the equipment's purchase cost, less any salvage value. Using depreciation, companies can keep track of the money recovered from sales revenue for the equipment purchased and used in operations.

References

• Entrepreneur: Depreciation