Financial Strategies: Depreciation Demystified

The theory behind depreciation expense is that when you buy a fixed asset, it's used to earn income over a length of time longer than a year and should be expensed over a period of years. This is the basis of the matching principle--the timing of recognizing revenue should match that of recognizing its attached expenses.

Then the IRS gets involved and logic goes out the window! This is where the concepts of book and tax depreciation arise. Book depreciation is based on the company's estimates of actual asset life, and is usually as simple as dividing cost by estimated life to determine the yearly amount to expense until the asset is fully depreciated on the financial statements. Most small businesses use tax depreciation for their internal bookkeeping.

The Internal Revenue Code (IRC) requires taxpayers to expense capital equipment purchases and buildings over their lifetimes and not in the year they are purchased. However,...