How should a company depreciate a capital expenditure? Is it something that is done at the point of purchase, or does it make more sense to depreciate the value of that fixed asset over time? Well, simply put, depreciating a fixed asset is considered a non-cash expense, one that allows a company to reduce the book value of the investment. Reducing the book value allows the company to reduce its earnings. So, why would a company want to reduce its earnings in such a scenario?
Depreciating Capital Expenditures
It’s important to understand that book value refers to the price of the fixed asset minus that asset’s depreciation. In essence, the value of the purchase is declining on paper, when in reality it could actually be growing in value. However, the company is able to use its reduced earning to reduce its taxes, without having to reduce the company’s available cash reserves. While this may sound somewhat complicated, it really is a fairly straightforward process.
There are ways to simplify how your company depreciates a fixed asset. First, we’ll define what constitutes a fixed asset and what can, and can’t, be depreciated. Then we’ll use a method commonly referred to as the “straight line depreciation” and show how your company can properly depreciate a capital expenditure over time.
What is a Fixed Asset?
A fixed asset is commonly referred to as a non-current asset. Examples of fixed assets would include any capital expenditures on buildings, real estate (property and land), equipment, machinery, office furniture and or any asset that either won’t, or can’t, be converted to cash within a period of one year. In fact, this is often the most important criterion companies use to determine whether to treat that purchase as an expense or a capitalized item.
There are essentially two main criteria for making such a decision. The first pertains to time: How long will the purchase be retained? If it’s longer than a year, then it’s likely to become a capitalized asset. If it’s shorter than a year, then it would likely be an expense, one the company would classify as a yearly expense and one seen as a cost of doing business. The second criterion includes the overall cost of the item itself. While there are no hard and fast rules when it comes to capitalizing an asset, it simply makes sense to capitalize large expenditures on fixed assets.
Can all Fixed Assets be Depreciated?
While land is considered a fixed asset, it simply isn’t one a company can depreciate over time. The reason being is that land lasts forever. In addition, depreciating an asset implies that asset’s value declines due to obsolescence and gradual damage. Land can’t lose its value due to obsolescence or damage, and a straight line depreciation model can’t account for a fixed asset whose longevity can’t possibly be defined. However, capital expenditures such as equipment and machinery most certainly can be depreciated.
These assets decrease in value due to obsolescence and damage. Again, the intention is to depreciate the equipment as a non-cash expense. This will allow the company to reduce the equipment’s book value. In turn, that will reduce the company’s earnings and those reduced earnings will reduce the company’s tax burden, without adversely affecting existing cash.
An Example of a Capital Expenditure
Let’s assume your company is a manufacturer, one that has lost market share due to the inability to increase your production capacity. You are forced to upgrade and need to purchase a new CNC (computer numerical control) machine. This purchase is large enough to be considered a capitalized asset. This is because of the asset’s sticker price and the fact that it can be depreciated over time. Upon purchasing that machine, you determine that it will last your company a maximum of 10 years. The total purchase is $200,000.00.
A straight line depreciation dictates that every year equates to the same depreciation percentage. Since the value of the purchase is $200,000.00, and the value of the asset is determined to last for 10 years, then its 10 percent of the $200,000.00 value, or $20,000.00 of depreciation, for each of the 10 years.
How Will This Affect the Company’s Financial Statements?
The depreciation of the fixed asset will have a direct effect on the company’s balance and income statements. For instance the company’s balance sheet must account for the depreciation cost. The company would have to reduce its earnings by $20,000.00 for each of the ten years. Again, the capitalized asset is termed a non-cash expense, so the company’s cash isn’t actually reduced. This is simply a reduction on “paper”. The company would then represent this as a depreciation expense on its income statement.
In our example, the company has reduced the book value of its CNC purchase. It has capitalized this particular fixed asset as it could not possibly expense the entire purchase in one single year. The company has used a straight line depreciation model to reduce the book value, which in turn reduces its earnings and allows it to lower its overall tax burden. Companies must be willing to quantify their expenditures relative to their value and time. Large capital expenditures like equipment, and machinery, are serious investments, ones meant to improve the company’s long-term future. When faced with a decision to go forward with a capital expenditure on equipment, take the time to define it as a capitalized asset. Since depreciation is a non-cash expense, your company can lower its earnings without lowering its cash reserves and use that to your advantage to lower your overall tax burden.
The above video explains how to compare financing with a bank versus finanincing with an asset-based solution like factoring. You can read more about this comparison by reading the following post: Sample Receivable Factoring Excel Sheet: Effective Rates & Interest Rates
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