After Tax Cash Flows From Operations Are Calculated As Demystifying Depreciation

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Demystifying Depreciation

If you’ve ever had to prepare a tax return for your business or read a business’s financial statements, you’ve heard of depreciation. And while accounting is not something everyone cares to understand, understanding depreciation is not a particularly difficult accounting concept reserved only for accountants and can prove to be a very valuable tool in your strategic management tool belt.

In short, depreciation is a means of calculating the true cost of an item, for a specific period (usually a financial year), when the life of the item exceeds that period. So this means that it is possible to account for the cost value of the item in a particular tax year (and deduct that portion from your taxable income), even if the useful life is 10 years.

Of course depreciation can only be calculated on items that are part of your capital expenditure and are considered assets such as cars, furniture and buildings. Inventory costs (operational costs) are not considered capital costs and therefore depreciable (even if you are a car dealer and your inventory includes cars).

Knowing this, you may have noticed that the depreciation (cost value) of an item is driven by the useful life of the item (capital asset). The presumption is that an item has a reasonable and expected life in which it will be useful to the business, and so the taxman agrees that you can deduct a percentage of the value from your taxable amount, over the life of the item. Income as expenditure.

To give some examples, a computer (perhaps 3 years) has a shorter lifespan than a desk (perhaps 10 years), and therefore the faster you can deduct the value of the item from your taxable income. , or slower depending on the item. So while it’s the same everywhere, be aware that this useful life expectancy is assigned by the tax man and set in stone based on the specific values ​​of your country or province.

Considering all this, one more key point needs to be understood. Capital assets cannot be fully deducted in a financial year. So if you bought a car for $20,000 (even if you paid cash for it), you can’t deduct the full $20,000 as an expense in one year. The tax man will consider this unfair as the car retains its value even after the first year.

If your taxman says it’s to be depreciated over 5 years, you can deduct only $4,000 of your expenses each year, until the entire value drops to $0 (maximum 5 years in this example).

Essentially, as the example illustrates, you still get the full value of the item as an expense, however instead of being expensed in one year, it is now spread over the item’s designated useful life.

Please note that this example only shows straight-line depreciation. There are other methods of calculating depreciation, and you should discuss those options with your financial advisor to ensure which option is right for your needs.

Now that you know what that means, here’s something to think about. When purchasing a capital asset, having a clear understanding of the impact of depreciation will make it much easier for you to properly assess the financial impact on your business, especially as it relates to your taxes and how it affects your overall cash flow.

One way in which depreciation is widely used is to offset the cost of financial capital assets. Finding the right balance between property financing costs and depreciation will make your purchase less expensive and can potentially have a positive impact on your cash flow as well. And if capital assets are something you still need, balancing these correctly can significantly reduce the overall cost of those assets, while actually improving your cash flow.

And since managing your taxes is just as important as managing your business, it will be worthwhile for you to properly plan the acquisition and sale of assets to ensure that the tax burden is reduced, resulting in lower asset prices and of course, improving your business. cash flow.

I wish you all the best in your endeavors and invite you to share your stories and experiences here.

Cheers!

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