Most business owners are familiar with the Profit & Loss Report, to most money you make is income and money that goes out is an expense. But that’s not always the case, an expense is something that gets used up rather quickly and therefore the benefit is used up quickly. Some examples are office supplies, you purchase during the year and they get used up during the year. But there are other purchases that tend to hold up business owners record keeping because even though money is being spent, it is not fully expensed the year they you use it. This can give you a incorrect analysis of your business and not match up when it comes to taxes.
Sometimes when you make a purchase it’s not an expense, it’s actually an asset. An asset is something where the usefulness is used up over the course of several years. It provides a benefit over a longer period of time. Examples include equipment, vehicles, or a computer.
As an example, when you purchase a vehicle and use it to deliver products, it’s providing a benefit to you over the course of much more than just one year. That’s the difference between an asset and an expense. Does the purchase benefit you over the course of a long period of time? An asset will help you continue to earn revenue over the course of several years.
Matching Revenues and Expenses
In accounting rules, revenue and its associated expenses should be recorded in the same period. This is called matching. Let’s say you purchased a camera and recorded the entire purchase as an expense in the year you purchased it — 2015. But the camera helps you earn money in 2015, 2016, 2017, 2018, 2019 . . . a long time. So the expense and the revenue aren’t matched up together. You’ve got revenue produced by the camera recorded over the course of several years, but the expense of the camera is only recorded in one year. The revenue and expense are not matched.
Matching is a very important accounting principle, the revenue and associated expense need to be matched together. This is where depreciation comes into play. The way you get the revenue and expense to match up, is to depreciate that asset over the course of several years.
Lets say you bought a $5,000 computer, that expense needs to spread out over how long you think you will have that computer. In other words, The expense needs to spread over the computer’s useful life – the period of time that it will be of benefit to you. Often for small equipment that’s 3-5 years. Let’s say you think the computer will last you 5 years, (i.e. it has a useful life of 5 years) you take $5,000/5 years=$1,000 of depreciation you should take each year on that computer.
In this way you are spreading out the expense to match the revenue you earn in future years.
Depreciation also serves to show that the asset you purchased is losing value every year. Let’s say you are a florist who purchased a vehicle to deliver flowers. It’s only used for business. You purchased the vehicle for $20,000 and you think it will last you for 10 years, so that’s $2,000 of depreciation every year. The car is helping you earn your revenue over the course of 10 years. When you take that depreciation each year, you can see that that car is losing value every year. After the first year of depreciation the asset is valued at $18,000, after the second year $16,000, and so on.
That makes sense in our heads. A car loses value every year. As the years go on, your asset is losing value. Depreciation shows that declining value.