Understanding depreciation: How it affects your end-of-year profits

Understanding depreciation: How it affects your end-of-year profits

Depreciation is a concept that can be confusing for small business owners, but understanding it is essential for managing your finances and accurately reporting profits.

When you purchase a significant asset, such as equipment, vehicles, or property, you cannot deduct the full cost of the asset as an expense in the year it is purchased. Instead, the cost is spread out over the asset’s useful life. This process, known as depreciation, aligns the expense with the revenue the asset generates over time.

Let’s break this down with an example:

• You buy an asset for $100,000 that has a 10-year lifespan.
• Instead of deducting the full $100,000 in Year 1, you claim 10% ($10,000) per year as depreciation.
• If your business income is $500,000 and other expenses are $400,000, the $10,000 depreciation is reported as an ‘expense,’ increasing expenses to $410,000. Your net profit is $90,000 in Year 1 ($500,000 minus $410,000)

This system allows you to gradually reflect the cost of the asset in your financial statements, providing a more accurate representation of your business’s profitability. However, it also presents challenges, particularly in the first year.

The first-year cash flow challenge

The difference to your bank balance is not the same as net profit.

If we take the same scenario:

• In Year 1, income is $500,000, expenses are $400,000, minus the $100,000 on the asset.
• Your total cash outflow for the year is $500,000, equal to your income.
• You have $0 in the bank but report a net profit of $90,000 (and pay income tax, even though the cash drawer is empty).

This dynamic (claiming the depreciation of an asset as an expense, not the full amount) can make Year 1 particularly challenging for small businesses relying on cash reserves.

When managing significant asset purchases, it’s essential to plan for the impact on your cash flow, as these expenses can strain your finances in the short term. Additionally, be mindful of the difference between your reported profits and your actual cash position, which may not align in the first year. Finally, remember that the benefits of depreciation will become more apparent over time, helping to reduce taxable income and improve financial stability in subsequent years.

The long-term benefits of depreciation

While Year 1 can be tough, depreciation begins to pay off in subsequent years.

Let’s revisit our example:

• In Years 2 through 10, your business continues to generate $500,000 in income with $400,000 in expenses.
• You can claim another $10,000 depreciation annually, keeping your reported net profit at $90,000.
• You’ll have $100,000 in the bank, but your reported net profit is only $90,000.

Depreciation continues to lower your taxable net profit each year, which helps reduce your tax liability.

Pro tips for leveraging depreciation

Maximizing the benefits of depreciation requires a strategic approach beyond simply claiming it each year. Begin by maintaining detailed records of all asset purchases, including invoices, receipts, and any associated documentation. Additionally, review your depreciation schedule annually to confirm it aligns with any changes in your business operations or tax laws.

Engaging a tax professional can help identify specific deductions or credits associated with your assets. For instance, certain energy-efficient equipment may qualify for additional tax incentives, further reducing your financial burden. They can also advise on using accelerated depreciation methods to optimize your tax strategy in years when your business generates higher profits.

Finally, incorporate depreciation planning into your broader financial forecasting. Understanding how depreciation impacts your net income and cash flow allows you to make informed decisions about future investments, ensuring that your asset purchases align with your long-term business goals.

Why some businesses lease or finance assets

Given the challenges of buying assets outright, many small businesses choose to lease or finance their purchases.

Advantages of leasing:

• As you don’t own the asset, you can claim 100% of the lease payments in the year they are paid.
• You don’t have to use cash reserves or borrow any cash.

Advantages of financing:

• Borrowing allows you to spread the cost over time and it’s usually cheaper in the long run to own the asset.
• Depreciation applies, because even with financing, you own the asset.

These strategies help businesses balance their need for assets with the realities of cash flow management.

Special rules and considerations

The IRS website provides specific guidelines for depreciation that every small business owner should understand.

Some assets may also be ‘expensed’, where you can claim 100% of the cost in Year 1 if it’s under a certain threshold. It’s a practical rule to save you having to list assets that, though they last more than a year, have a low value, like a phone.

• De Minimis Safe Harbor Election. For items costing $2,500 or less, businesses can expense the full cost in the year of purchase rather than depreciating over time.
• Some states have different rules regarding depreciation. You must consult with a tax advisor so that you’re compliant with both federal and state laws.

These provisions are designed to make depreciation more flexible for small businesses, allowing you to deduct smaller purchases immediately and reserve depreciation for larger investments.

Make sure you evaluate each purchase to determine whether it qualifies for immediate expensing or depreciation and keep detailed records of all assets and related expenses to simplify tax filing.

Next steps

• Review your current asset purchases and determine their useful life for depreciation purposes.
• Budget for the impact of asset purchases on cash flow and profitability in the first year.
• Consider whether leasing or financing might be a better option for your business.
• Track your cash flow and reported profits to maintain a clear understanding of your financial health.

Depreciation is a powerful tool to help you align your financial strategy with your business goals. While the initial impact of asset purchases can strain cash flow, depreciation provides long-term benefits by reducing taxable income over time. By planning carefully, leveraging tax provisions, and seeking professional guidance, you can navigate the complexities of depreciation and build a stronger financial foundation for your business.