Depreciation is a cost estimation method for accounting for the worth of a long-term asset over its useful life. Depreciation is used to spread the cost of a tangible asset over the accounting periods in which the asset is used. There are some questions surrounding this topic that are essential to explore. For instance, what are the tax implications of depreciation? What are the different depreciation methods, and how can they be used to calculate the amount? What are the best practices for managing depreciation? How does depreciation help to ensure a company’s financial health? Each of these questions will be explored in more detail to understand the concept of depreciation fully.
Since antiquity, depreciation has been utilized for cost apportionment. Initially, the idea was developed by the Greek philosopher Aristotle, who believed that the value of an asset declined over time. By the 19th century, Italian economist Vilfredo Pareto formalized this notion and proposed that the cost of an asset be distributed over its useful life. This proposal was developed further by Karl Marx, who argued that the cost of an asset should be spread out over its useful life, as opposed to being written off in the year of purchase. In the modern age, accountants have adopted this concept, which companies now utilize to accurately reflect the cost of long-term assets in their financial reporting.
The tax implications of depreciation are important to consider. The first tax implication of depreciation is that it reduces taxable income. When a business depreciates an asset, the cost of the asset is spread over multiple years, reducing the amount of taxable income in the current year. Thus, businesses can lower their taxes in the current year and defer taxes to future years. Secondly, depreciation can offset the income from the asset’s sale. When an asset is sold, any depreciation claimed can be used to offset the gain from the sale. This reduces the taxable income from the sale and can result in a lower tax bill for the business. Moreover, depreciation can be utilized to increase the tax basis of an asset. When an asset is sold, the asset’s tax basis is used to calculate the gain or loss from the sale. An asset’s tax basis is raised through depreciation, which lowers the gain from sale and may lead to a smaller tax bill.
The most common depreciation methods are straight-line, double-declining balance, and units-of-production depreciation.
- Straight-line depreciation is the simplest and most widely used method of depreciation. It is calculated by dividing the cost of an asset minus its salvage value by its expected useful life. This creates a fixed depreciation expense for each year of the asset’s life. Straight-line depreciation is best used for assets that have actual usage over their lifetime, such as office furniture or computers.
- Double-declining balance depreciation is a method of accelerated depreciation. It is calculated by multiplying the asset’s book value at the start of the year by a predetermined depreciation rate that is twice the straight-line rate. The resulting depreciation charge is then subtracted from the asset’s book value to arrive at the book value for the following year. This method is most suited for assets with a high rate of obsolescence or deterioration.
- Units-of-production depreciation is a depreciation method used to calculate the depreciation of an asset based on its usage. It is calculated by dividing the total cost of the asset by its expected lifetime usage. The depreciation amount is then allocated evenly over the asset’s estimated useful life or until the asset is fully depreciated. This method is typically used when the asset is used for a specific purpose, such as production or transportation, and its expected lifetime usage can be estimated. This method is used when the asset’s usage can be easily monitored and tracked, such as a machine or vehicle.
Companies should manage depreciation to properly control their assets. This can be accomplished by estimating the asset’s expected useful life and comparing it to the useful life set by the IRS or other regulatory bodies. Useful life is the estimated time an asset can be used or the period over which its benefits are expected to be realized. The IRS sets a useful life for certain assets that it considers depreciable, but companies can also estimate the useful life of other assets. Moreover, a firm must select the most appropriate depreciation technique after considering the asset’s characteristics and the company’s financial needs. It should consider the asset’s purchase price, estimated useful life, and residual value.