Is depreciation capital expenditure or income expenditure

Depreciation in accounting: what's behind it?

The economic importance of depreciation

In accounting, depreciation is used to distribute the cost of a purchase, for example an investment object, over its service life. The depreciation ensures that the profits are evenly burdened by the investment over the life of the acquisition.

An example should clarify this. Let us assume that an entrepreneur buys a machine for 40,000 euros that he will use for 5 years. If there were no depreciations, these 40,000 euros would appear immediately in the income statement and reduce the profit by 40,000 euros. Since he writes off the machine over 5 years, the reduction in profit is only 8,000 euros per year.

Acquisition of a machineYear 1Year 2Year 3Year 4Year 5
Investment / purchase price40,000 euros    
Case 1: No depreciation     
Profit reduction (P&L)40,000 euros0 euros0 euros0 euros0 euros
Value of the machine on the balance sheet0 euros0 euros0 euros0 euros0 euros
Case 2: with depreciation     
Depreciation per year8,000 euros8,000 euros8,000 euros8,000 euros8,000 euros
Profit reduction per year8,000 euros8,000 euros8,000 euros8,000 euros8,000 euros
Value of the machine on the balance sheet32,000 euros24,000 euros16,000 euros8,000 euros0 euros

The table shows the effect very nicely. If there were no depreciation, the investment would charge the profit in full to the amount invested. In the year of purchase, this would result in a very large reduction in profit and thus the taxes to be paid. In the following years until the end of use, however, buying the machine has no effect. In addition, the machine would not appear on the balance sheet as an asset.

With the concept of depreciation, however, the profit is evenly burdened. In addition, the machine appears as an asset on the balance sheet. If an investor looks at the company's balance sheet at the beginning of the second year, he sees that the company's assets include a machine that is currently valued at 36,000 euros.

Depreciation can therefore be justified by the fact that, for example, investment objects are used for longer than a financial year, but the value of an object decreases over time. This can be due to the following reasons:

  • Wear: Objects, machines wear out
  • Objects become obsolete: this is the case with software or fashionable goods
  • Rights are subject to time restrictions, e.g. licenses

For example, properties are not subject to wear and tear. Anyone who purchases a piece of land is therefore not allowed to write it off. A building, on the other hand, may very well be written off. Let's summarize what you as a founder must or are allowed to write off:

  • Fixed assets: buildings, plants, machines, software, licenses
  • Current assets: inventory, accounts receivable

So once you start investing, you need to know that these investments will reduce your bottom line through depreciation. In addition, the value of these investments on the balance sheet decreases over time. The following types of capital goods are particularly relevant for founders and companies?

Depreciation and asset accounting

If you buy capital goods of the fixed assets, a so-called fixed asset accounting is carried out in the bookkeeping. This is usually done by your tax advisor, unless you do your accounting yourself. In this asset accounting, the following is noted for each item:

  • Name of the item and account number according to the chart of accounts
  • Purchase date
  • acquisition cost
  • Depreciation of the item in the current financial year
  • Total depreciation to date
  • If an object is completely written off, it appears as a reminder item in the asset accounting with the value of 1 euro.

When preparing your financial statements, you need to go through this fixed asset accounting and confirm that the item in question is still in fixed assets. In a sense, this is the inventory of fixed assets.

Scheduled and unscheduled depreciation

When making an investment, plan the useful life of that asset. So the depreciation is on schedule. Example: You buy a machine and plan to use this machine for 5 years. If the machine breaks after 2 years, it must be written off before the end of its useful life. This is then an unscheduled depreciation.

Scheduled depreciation is depreciated on a straight-line basis. The calculation of straight-line depreciation is simple: you divide the acquisition costs by the planned or permissible useful life and thus get the depreciation amount per year.

Is relevant again from 2021 the declining balance depreciation, at which the depreciation rates are very high at the beginning of the useful life and become lower and lower over time. Progressive depreciation, the opposite of declining balance depreciation, in which the depreciation amounts increase over time per year, is no longer permitted today and is therefore not relevant for you as the founder.

Here is a table that shows you how to calculate your depreciation amounts.

 CostUseful lifeDepreciation amount per year
Example: shop fitting400,000 eurosten years40,000 euros
Example: New website6,000 euros3 years2,000 euros
Example: car28,500 euros6 years4,750 euros

So you can see that it is very easy to calculate depreciation. For example, when you set up your business plan, you can plan for depreciation when creating the investment plan.

But how is it when, for example, you buy software for € 120. Do you also have to write them off over the permitted period, which in the case of software is currently 3 years? Wouldn't that be very time-consuming, given the large number of goods with low prices that are used in companies? For this purpose, there is the regulation for low-value assets, which we will introduce in the next section.

Depreciation tables (depreciation tables): determine the useful life

You will of course be wondering where you can get information about useful life and planned depreciation periods. The answer is: via depreciation tables - in short, depreciation tables. In the depreciation tables, the tax office regulates which assets may have which useful life. On a separate page, we present the most important information about depreciation tables and give you numerous practical examples of the useful lives of a wide variety of assets.

Depreciation of low-value assets (GWG depreciation)

Of course, you don't want to record every small investment in asset accounting. The legislature also sees this. Therefore, depending on the purchase price, you may write off low-value assets immediately or in a collective item. The principle of immediate write-off should be clear. Depreciation in the collective item means that you do not enter the individual items that you purchase individually, but as a total. You write off this collective item over 5 years.

The following table shows you the regulations that you must observe for the annual financial statements for 2017. We will also introduce you to the regulations from 2018.

Regulation until December 31, 2017 for annual financial statements until 2017
Purchase price0 to 150 euros150.01 to 410 euros410.01 to 1,000 euros
 Immediate depreciation or deduction as business expenses.Immediate depreciation or deduction as business expenses. Or alternatively, the creation of a collective item and depreciation over 5 years.Creation of a compound item and depreciation over 5 years.
Regulation from 1.1.2018
Purchase price0 to 250 euros250.01 to 800 euros800.01 to 1,000 euros
 Immediate depreciation or deduction as business expenses.Immediate depreciation or deduction as business expenses. Or alternatively, the creation of a collective item and depreciation over 5 years.

Creation of a compound item and depreciation over 5 years.

Important: you must enter the assets in the compound item in a separate record if the accounting does not reveal exactly what type of item it is. Example: You buy a drill for 300 euros in a hardware store. The item does not appear on the receipt. Then you have to record the drill in its own directory. If the drilling machine is clearly visible on the invoice, you do not need the recording.

When can depreciation have a detrimental effect on the income statement?

Scheduled depreciation is unproblematic in normal, profitable business. On the contrary: if your company is operating profitably, depreciation reduces profits and is advantageous for tax purposes. In addition, depreciation has a liquidity effect, as the posted expense in the form of depreciation does not lead to a cash outflow.

In the event that a company writes losses, however, all costs are basically too high. In such a case, depreciation contributes to the loss situation. Then, as part of the restructuring, it must be checked whether it is possible to sell assets in order to reduce the amount of depreciation in addition to securing liquidity.

On the other hand, unscheduled depreciation is also dangerous in regular business operations. For example, when a machine breaks down or a building burns down. In such a case, you need good commercial insurance in order to replace the damaged goods in the event of damage and an unscheduled total write-off. It is bad for someone who does not have adequate insurance in the event of damage and is financially unable to replace a broken down important machine or a burned down building.

Unscheduled write-offs of receivables are also problematic. They occur when your customer can no longer pay their bill and becomes insolvent. To prevent this, you need good accounts receivable management or credit default insurance. On the other hand, factoring, as a form of pre-financing of invoices, helps prevent high customer demands from arising in the first place.

How to plan economically with depreciation

For all business planning, you have to include depreciation, regardless of whether you, the founder, draw up your financial plan or apply for a loan for a business expansion in the growth phase.

  • Investment planning: When planning your investment, you determine which goods you need for your project and then calculate which depreciation will result from them.
  • Financial planning: Depreciation is a cost and therefore belongs in the cost planning. As costs, depreciation reduces your planned operating profit and your planned profit before and after taxes.
  • Cash flow calculation: For any cash flow planning, you need to consider depreciation. Because depreciation is a cost that does not lead to an outflow of funds. For the cash flow calculation, add the depreciation to the operating result.
  • Create budget balances:You also need depreciation for a planned balance sheet, because the planned balance sheet requires the current inventory of assets (asset accounting), investment planning, cash flow planning and P&L planning. The depreciations are available in all of these calculators.

This overview is intended to make it clear to you how important depreciation is in accounting as a whole. It is a broad field with many detailed regulations. A good tax advisor will help you grasp these relationships and take them into account correctly.

Conclusion on the subject of depreciation in accounting

Depreciation therefore documents the loss in value of assets in accounting. While the investment leads to a direct outflow of liquidity, depreciation in the income statement does not result in any expenses affecting liquidity. They are justified by wear and tear, obsolescence and legal regulations. Depreciation is important for determining profit (annual financial statements, P&L, BWA) as well as for business planning (liquidity and earnings planning). It is a broad, fragmented field full of regulations and pitfalls. A tax advisor will help you keep track of things here.

Author: Für-Gründer.de editors

As editor-in-chief, René Klein has been responsible for the content of the portal and all publications by Für-Gründer.de for over 10 years. He is a regular interlocutor in other media and writes numerous external specialist articles on start-up topics. Before his time as editor-in-chief and co-founder of Für-Gründer.de, he advised listed companies in the field of financial market communication.