Why some costs are not immediately deductible
Hello All,
Depreciation is one of those accounting terms that sounds like technical jargon, but is actually conceptually straightforward. It simply refers to the measure by which asset will lose value over time. For example when you buy a car (which are notorious for losing a significant amount of value as soon as you drive it off the car dealership parking lot), it will be worth less each year as it starts to deteriorate. Finally, at some point in the future you will have to replace it.
Depreciation is primarily a function of time and usage. From an accounting perspective, when you buy an asset you have to determine whether it has a useful life that extends beyond one or a few uses. Materials that you buy to make your product that you will then sell are used only once. A subscription that you pay for monthly for rent or software is only good for that month. Paper for your printer is used on an ongoing basis. (There are also some items that may have a useful life that extends beyond a year such as a pen or a bottle of glue, but because they are so small, there is very little value to tracking them.)
Depreciation comes into play when you have a larger value item, such as a computer, that will last several years. Consequently, from an accounting perspective, the expense of the computer is only accurately represented when it is spread out over the life of the computer. If you expensed it immediately, your expenses would be overstated in year 1 and understated in every subsequent year. This results in an inaccurate profit and loss statement and reduces the effectiveness of the analysis of your financial results.
From a tax perspective, Revenue Canada refers to depreciation as capital cost allowance (CCA). Since it would be extremely time consuming (and still inaccurate) to try and come up with an estimated useful life of each individual asset, they have established a series of classes that has a rate of depreciation. Computers go into Class 50 with a rate of 55% of net depreciated amount (see my blog post for how this works). Furniture goes into Class 8 with a rate of 20%. And so on.
Since these assets, with a useful like exceeding one year cannot be expensed right away, they must be depreciated. By defining a class and a rate, it greatly simplifies the calculation and makes it less arbitrary.
So, as a business owner it is important to evaluate the items that you purchase for your business, determine if they have a useful life that exceeds one year. If so, they should be recorded as fixed assets in your accounting and tax return and depreciated appropriately.
