What Is Meant by Capital Depreciation?

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Credit: Lenny Kuhne

 

Running a business is hard work, and business expenses and operations rely on not just strategic vision, but awareness of key financial metrics across the organization. One of those key concepts is capital depreciation. What is meant by capital depreciation?

Simply put, capital depreciation is the concept that capital assets lose value over time. The clearest way to explain capital depreciation is to look at computer technology, one of the top spending centers within today’s companies.

According to TechRepublic, the average company replaces their equipment every five years. If a specialized workstation costs $20,000, but only can stay deployed for five years before replacement is required, then each year the value goes down by $4,000.

After three years, the workstation is only worth $8,000. The capital depreciation involved is $12,000.

These are simplified numbers; depreciable assets will have their own calculations to keep track of. The IRS, for instance, maintains depreciation tables that show how to calculate depreciation of a variety of assets for tax purposes. Maintaining the financial health of the business is incredibly important.

 

Factors Behind Depreciation of Capital Assets

What causes the depreciation of capital assets? Multiple factors exist behind depreciation, including the following:

  • Obsolete technology
  • Changing demand for the item in the marketplace
  • Resale value fluctuations
  • Too costly to repair the asset

Depreciation is important because it’s reported on the income statement as an operating expense. In fact, it is subtracted from the company’s revenue in order to come up with the net income amount.

Accounting for depreciation accurately is very important. Depreciation is similar to amortization as it is considered a non-cash component of the operating costs companies experience. Multiple depreciation methods abound, but it’s important to select one to use consistently for best results.

 

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Examining the Depreciation of Capital Equipment

In most cases, the consumption of fixed capital (depreciation) can be determined by looking at the original cost, the total lifespan of the asset, and the salvage value at the time of decommissioning. Sometimes there is no salvage value to record; not all depreciable property can simply be sold even at a loss.

Understanding the depreciation of capital equipment is key to gaining clarity around how assets are not just acquired, but consumed within the business. A characteristic of a fixed asset is that it is always a physical, tangible item like computers, land, and buildings.

 

The Balance Sheet: The Bigger Picture

To see how depreciation or consumption of fixed capital depreciation measures work at a higher level, it’s time to shift focus to the balance sheet. This document summarizes all of the company’s assets, liabilities, and equity.

The classic capital equipment definition is straightforward: it is an item that costs at least $5,000 or more per unit and has a lifespan of more than one year.

Capital equipment is considered a noncurrent asset, which means that it’s depreciated over the length of its useful life. The formula for depreciable cost is the purchase price minus the total depreciation. Several of these terms have overlap but are still important to get familiar with the lingo.

Depreciation of Capital Assets

Credit: Pascal Meier

 

Organizing Depreciation With Key Business Objectives in Mind

Every asset has to earn its proverbial keep in a business, and capturing depreciation helps the company see where money is not only going over time but how these assets decrease in value over time.

Unfortunately, a company that experiences exponential growth can run into problems with keeping organized. Unlocking higher business objectives and vision often requires working with an outside company on accounting process refinement to keep all records in great shape, as well as to strengthen other underlying reporting mechanisms.

Strategic decisions based on sound financial management are the difference between good growth and great growth.

 

Make Better Financial Decisions With Michigan CFO Associates

We provide all the services you’d receive from an in-house CFO, either virtually or in-person. Contact us to learn more and get started.

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