Budgeting and Depreciation

Calculating depreciation is part of the budgeting process for a business in the accrual method of accounting but doesn't have much impact for an individual putting together a family budget, with the exception of understanding the rate of depreciation on the automobile the family owns. Companies using the cash method of accounting don't have to be concerned with depreciation for their business assets.

Budgeting is simply determining what you think your company will earn by forecasting revenues and expenses on a monthly basis. If revenues are higher than expenses, the company is earning a profit. The forecast is based on known expenses such as leases, rental expenses, utilities, and wages and expenses based on sales such as inventory purchases. If the business uses the accrual method of accounting, one of the expenses is depreciation.

For an individual, depreciation is how much value an asset loses over time. Most individuals are only concerned with depreciation when they buy a car. The car immediately is less valuable once driven off the lot because it is no longer a new car but is considered used. Individuals sell or trade in their old car when they buy a new one. Depreciation is the difference in value between the price the car was sold for when new and the current trade-in value of the car.

Depreciation is a method of matching the expense of an asset over time with the income produced from using it over that same time period. It is used in the accrual method of accounting, which is difficult to understand unless you're an accountant and deal with all those pesky debits and credits on a daily basis.

Let's say you buy a new computer network for $50,000 and pay cash. That network will service your business for the next five years. Depreciation is taking a portion of that $50,000 and prorating over that timeline. That makes sense because you're not using up all the value in the system the first year, even though you paid for it in the first year.

If depreciation isn't a complicated enough topic, there's accelerated depreciation. The simple way to reflect depreciation in a balance sheet is to simply divide the acquisition cost – which is a fancy way of saying what you paid for it – by the number of years the acquisition is reasonably expected to last. Accelerated depreciation says that the asset will be used up more quickly in the first years after acquisition and that should be reflected in the balance sheet. So instead of simply dividing the cost by the number of years, a formula is used to charge off more depreciation in the early years than later.

The cash outlay occurs when you bought that computer network in the first year. The depreciation is an expense and is subtracted from the income the company generates but doesn't reduce the amount of cash the company has. You only pay for the asset once when it's acquired.

You can't use up land. The value of the land doesn't depreciate like the building itself that will have to be replaced eventually. That usage is reflected by depreciating the building over its expected lifetime. What complicates matters is when real estate values go up, it's tempting to think that the building is worth more on the balance sheet. That's not the case unless the building is actually sold at the increased value.