depreciation

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Depreciation

The gradual decline in the financial value of property used to produce income due to its increasing age and eventual obsolescence, which is measured by a formula that takes into account these factors in addition to the cost of the property and its estimated useful life.

Depreciation is a concept used in accounting to measure the decline in an asset's value spread over the asset's economic life. Depreciation allows for future investment that is required to replace used-up assets. In addition, the U.S. Internal Revenue Service allows a reasonable deduction for depreciation as a business expense in determining taxable net income. This deduction is used only for property that generates income. For example, a building used for rent income can be depreciated, but a building used as a residence cannot be depreciated.

Depreciation arises from a strong public policy in favor of investment. Income-producing assets such as machines, trucks, tools, and structures have a limited useful life—that is, they wear out and grow obsolete while generating income. In effect, a taxpayer using such assets in business is gradually selling those assets. To encourage continued investment, part of the gross income should be seen as a return on a capital expenditure, and not as profit. Accordingly, tax law has developed to separate the return of capital amounts from net income.

Generally, depreciation covers deterioration from use, age, and exposure to the elements. An asset likely to become obsolete, such as a computer system, can also be depreciated. An asset that is damaged or destroyed by fire, accident, or disaster cannot be depreciated. An asset that is used in one year cannot be depreciated; instead, the loss on such an asset may be written off as a business expense.

Several methods are used for depreciating income-producing business assets. The most common and simplest is the straight-line method. Straight-line depreciation is figured by first taking the original cost of an asset and subtracting the estimated value of the asset at the end of its useful life, to arrive at the depreciable basis. Then, to determine the annual depreciation for the asset, the depreciable basis is divided by the estimated life span of the asset. For example, if a manufacturing machine costs $1,200 and is expected to be worth $200 at the end of its useful life, its depreciable basis is $1,000. If the useful life span of the machine is 10 years, the depreciation each year is $100 ($1,000 divided by 10 years). Thus, $100 can be deducted from the business's taxable net income each year for 10 years.

Accelerated depreciation provides a larger tax write-off for the early years of an asset. Various methods are used to accelerate depreciation. One method, called declining-balance depreciation, is calculated by deducting a percentage up to two times higher than that recognized by the straight-line method, and applying that percentage to the undepreciated balance at the start of each tax period. For the manufacturing machine example, the business could deduct up to $200 (20 percent of $1,000) in the first year, $160 (20 percent of the balance, $800) the second year, and so on. As soon as the amount of depreciation under the declining-balance method would be less than that under the straight-line method (in our example, $100), the straight-line method is used to finish depreciating the asset.

Another method of accelerating depreciation is the sum-of-the-years method. This is calculated by multiplying an asset's depreciable basis by a particular fraction. The fraction used to determine the deductible amount is figured by adding the number of years of the asset's useful life. For example, for a 10-year useful life span, one would add 1, 2, 3, 4, 5, 6, 7, 8, 9, and 10, to arrive at 55. This is the denominator of the fraction. The numerator is the actual number of useful years for the machine, 10. The fraction is thus 10/55. This fraction is multiplied by the depreciable basis ($1,000) to arrive at the depreciation deduction for the first year. For the second year, the fraction 9/55 is multiplied against the depreciable basis, and so on until the end of the asset's useful life. Sum-of-years is a more gradual form of accelerated depreciation than declining-balance depreciation.

Depreciation is allowed by the government as a reward to those investing in business. In 1981, the Accelerated Cost Recovery System (ACRS) (I.R.C. § 168) was authorized by Congress for use as a tax accounting method to recover capital costs for most tangible depreciable property. ACRS uses accelerated methods applied over predetermined recovery periods shorter than, and unrelated to, the useful life of assets. ACRS covers depreciation for most depreciable property, and more quickly than prior law permitted. Not all property has a predetermined rate of depreciation under ACRS. The Internal Revenue Code indicates which assets are covered by ACRS.

Further readings

Brestoff, Nelson E. 1985. How to Write Off Your Down Payment. New York: Putnam.

Hudson, David M., and Stephen A. Lind. 1994. Federal Income Taxation. 5th ed. St. Paul, Minn.: West.

Cross-references

Income Tax; Taxable Income.

depreciation

n. the actual or theoretical gradual loss of value of an asset (particularly business equipment or buildings) through increasing age, natural wear and tear, or deterioration, even though the item may retain or even increase its replacement value due to inflation. Depreciation may be used as a business deduction for income tax reduction, spread out over the expected useful life of the asset (straight line) or at a higher rate in the early years of use (accelerated).

See: contempt, criticism, damage, decline, decrease, denunciation, depression, deterioration, diatribe, disapprobation, disdain, disparagement, disregard, disrespect, revilement, stricture, wear and tear

depreciation

the accounting practice whereby the cost of a fixed asset is written off over the period of its expected useful life. The amount written off is a recognized deduction in computing the profits of a business. It is not allowable for tax purposes but CAPITAL ALLOWANCES may be given.
References in periodicals archive ?
The depreciation expense recorded the first year is: Depreciation expense = $15,000 x 2 x (1 / 5) = $6,000 The next year the book value is: Cost - Accumulated depreciation $15,000 - 6,000 = $9,000 The depreciation expense recorded the second year is: Depreciation expense = $9,000 = 2 = (1 = 5) = $3,600 The book value for the third year is: $15,000 - 6,000 - 3,600 = $5,400 The depreciation expense for the third year is: Depreciation expense = $ 5,400 x 2 x (1 / 5) = $2,160 The book value for the fourth year is: $15,000 - 6,000 - 3,600 - 2,160 = $3,240 The book value is only $240 above the salvage value, so depreciation expense for the fourth year is: Depreciation expense = $3,240 - 3,000 = $240 The book value is: $15,000 - 6,000 - 3,600 - 2,160 - 240 = $3,000
Eliminate the accumulated depreciation against the gross carrying amount of the asset and then restate the net amount to the revalued amount of the asset.
Many of these assets will be fully depreciated by the time that they are discarded, so the amount for Accumulated Depreciation will be the base.
If a company owning the sample asset had not included any provision for retirement costs in its annual depreciation amounts, its accumulated depreciation balance at the end of year 4 would be $400,000 ($1 million original cost over 10 years x 4 years of depreciation).
A few companies recorded a liability for part of their future decommissioning costs and credited accumulated depreciation for the remainder.
ACRS ACRS straight-line Original basis $ 1,000,000 $ 1,000,000 Accumulated depreciation through Dec.
GASB provides ways to estimate historical cost and to calculate accumulated depreciation and depreciation at transition.
If any of the original assumptions change, a recalculation of the obligation and subsequently associated expenses should be recorded as a change in accounting estimate, which is then offset by an increase in the asset's value, less any accumulated depreciation.
If an asset retirement obligation exists, the company must recognize amounts on the balance sheet for the liability adjusted for cumulative interest, the asset retirement cost, and accumulated depreciation.
Gain to the extent of accumulated depreciation on real estate; and
Similar to the process followed in the business sector, accumulated depreciation consists of the total amount of annual depreciation charges on depreciable assets since the date they were put into service.
1, 2000, when the building had $200,000 of accumulated depreciation and a remaining recovery period of 21.

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