Depreciation is an accounting and finance term for the method of attributing the cost of an asset across the useful life of the asset. Depreciation is often mistakenly seen as being a basis for recognising,"wear and tear", obsolescence, or impairment on an asset but these issues where seen as significant enough to account for are handled through an asset revaluation reserve. The use of depreciation affects a company's (or an individual's) financial statements, and, in some countries, their taxes.
A company needs to report depreciation accurately in its financial statements in order to achieve two main objectives. Firstly, to match its expenses with the income generated by means of those expenses. Secondly, to ensure that the asset values in the balance sheet are not overstated: an asset acquired in Year 1 is unlikely to be worth the same amount in Year 5.
Depreciation is an average or expected view of the decline in value of an asset. For example, an entity may depreciate its equipment by 15% per year. This rate should be reasonable in aggregate (such as when a manufacturing company is looking at all of its machinery), but there is no expectation that each individual item declines in value by the same amount.
Accounting standards bodies have detailed rules on which methods of depreciation are acceptable, and auditors will express a view if they believe the assumptions underlying the estimates do not give a true and fair view.
A write-down is a form of depreciation. It's a partial write off. Only part of the value of the asset is removed from the balance sheet. The reason may be that the accounted value of the fixed asset diverges from the market value.
For historical cost purposes, assets are recorded on the balance sheet at their original cost. Depreciation is not taken out of these assets directly. It is instead recorded in a contra asset account: an asset account with a normal credit balance, typically called "accumulated depreciation". Balancing an asset account with its corresponding accumulated depreciation account will result in the net book value. The net book value will never fall below the salvage value, meaning that once an asset is fully depreciated, no further expenses will be taken during its life. Companies have no obligation to dispose of depreciated assets, of course, and many depreciated assets continue to generate income.
Recording a depreciation expense will involve a credit to an accumulated depreciation account. The corresponding debit will involve either an expense account or an asset account which represents a future expense, such as work in process. Depreciation is recorded as an adjusting journal entry.
There are several methods for calculating depreciation, generally based on either the passage of time or the level of activity (or use) of the asset.
Straight-line depreciation is the simplest and most often used technique, in which the company estimates the "salvage value" of the asset after the length of time over which it is depreciated, and assumes the drop in the asset's value is in equal, yearly increments over that amount of time. The salvage value is an estimate of the value of the asset at the time it will be sold or disposed of; it may be zero. For example, a vehicle that depreciates over 5 years, is purchased at a cost of US$17,000, and will have a "salvage value" of US$2000 will depreciate at US$3,000 per year. (17,000 - (5 x 3000)) = 2000
If the vehicle were to be sold and the sales price exceeded the depreciated value (net book value) then the excess depreciation would be considered as income by the tax office.
If a company chooses to depreciate an asset at a different rate from that used by the tax office then this generates a timing difference in the income statement due to the difference (at a point in time) between the taxation department's and company's view of the profit.
The declining-balance method is a type of accelerated depreciation, because it recognizes a higher depreciation cost earlier in an asset's lifetime. This may be a more realistic reflection of an asset's actual resale value, as well as the expected benefit from the use of the asset: many assets are most useful when they are new. In the U.S., a form of declining-balance depreciation, MACRS, is used for tax purposes.
In declining-balance depreciation, each period's depreciation is based on the previous year's net book value, the estimated useful life, and a factor.
When a company spends money for a service or anything else that isn't a tangible asset, this expenditure is usually immediately tax deductible, and the company enjoys an immediate tax benefit.
However, when a company buys some physical asset Industrial Equipments that will last longer than one year, like a computer, car, or building, the company cannot immediately deduct the cost and enjoy an immediate tax benefit. Instead, the company must depreciate the cost over the useful life of the asset, taking a tax deduction for a part of the cost each year. Eventually the company does get to deduct the full cost of the asset, but this happens over several years; the number of years depends on an estimate of how long it typically takes that type of asset to become effectively useless, and require a replacement. Paper Shredders A computer may depreciate completely over five years; a factory building, over 30 years. The maximum allowable useful life estimate under U.S. income tax regulations is 40 years. Other countries have other systems, many of which remove the choice of depreciation rate and method from the company altogether. In these jurisdictions accounting depreciation and tax depreciation are almost always significantly different numbers, as in many instances a form of "accelerated depreciation" can be used for tax purposes to lower net income (or, in some instances, a fixed asset may be allowed to be expensed for tax purposes; Section 179 of the Internal Revenue Code allows for this treatment in some circumstances).
If property you acquire to use in your business is expected to last more than one year, you generally cannot deduct the entire cost as a business expense in the year you acquire it. You must spread the cost over more than one tax year and deduct part of it each year on Schedule C. This method of deducting the cost of business property is called depreciation.
What property can be depreciated? You can depreciate property if it meets all the following requirements.
- It must be property you own.
- It must be used in business or held to produce income.
- It must have a useful life that extends substantially beyond the year it is placed in service.
- It must have a determinable useful life, which means that it must be something that wears out, decays, gets used up, becomes obsolete, or loses its value from natural causes. You never can depreciate the cost of land because land does not wear out, become obsolete, or get used up.
- It must not be excepted property. This includes property placed in service and disposed of in the same year.