What is depreciation?

Depreciation is the systematic allocation of an asset's cost over its useful life, reflecting that long-term assets lose value through use, age, and obsolescence. For professional service firms, depreciation applies to equipment (computers, furniture, vehicles), leasehold improvements, and software. A consulting firm purchasing $30,000 in laptops doesn't expense the full cost immediately; instead, it depreciates the cost over 5 years at $6,000 annually. Depreciation is a non-cash expense: it reduces taxable income and net income without affecting cash flow.

Key characteristics of depreciation

• Non-cash expense: Reduces profit but doesn't require a cash payment

• Methods: Straight-line (even amounts yearly), accelerated (larger amounts early)

• Applicable life standards: Computers 5 years, furniture 7 years, vehicles 5 years, buildings 39 years

• Tax benefit: Depreciation expense reduces taxable income

• Alternative: Section 179 allows immediate expensing up to $1.16M (2024)

• Appears on: Both the income statement (expense) and the balance sheet (accumulated depreciation)

Why depreciation matters for service firms

Depreciation affects both taxes and financial statement accuracy. A service firm investing $50,000 in equipment can either: (1) Expense immediately via Section 179, reducing current-year taxable income by $50,000, or (2) Depreciate over 5 years at $10,000 annually, spreading tax benefit across five years. Section 179 immediate expensing is typically optimal for profitable service firms wanting to minimize current-year tax. Understanding depreciation prevents confusion: a firm showing $40,000 net income but only $12,000 cash generated likely has $28,000 in depreciation and other non-cash expenses bridging the gap.

Example: Equipment depreciation for a consulting firm

January 2024 purchase:

• 15 new laptops: $30,000

• Office furniture: $12,000

• Conference room tech: $8,000

• Total equipment: $50,000

• Depreciation method: Straight-line, 5-year useful life

Annual depreciation expense:

• Laptops: $6,000 per year

• Furniture: $2,400 per year (7-year life)

• Conference tech: $1,600 per year

• Total annual depreciation: $10,000

• Monthly P&L impact: $833 depreciation expense

• Alternative: Section 179 immediate expensing

• Expenses totaled $50,000 in 2024

• Reduces 2024 taxable income by $50,000

• Tax savings at 35% effective rate: $17,500

• Better for profitable firms wanting current-year deduction

Balance sheet treatment:

• Equipment (asset): $50,000

• Less: Accumulated depreciation: -$10,000 (after year 1)

• Net book value: $40,000

• Cash flow impact: $0 (one-time $50,000 outflow at purchase, depreciation is non-cash)