Depreciation

What It Means

Depreciation is the decline in the value of an asset (an item someone owns) over time. For example, it is said that a new car begins depreciating (losing value) the moment the buyer drives it off the dealer’s lot. This means that if an owner who paid $18,000 for a car tries to sell the vehicle one month later, that same car may only be worth $16,000.

Assets lose their value for a number of reasons, including use, age, exposure to weather, and obsolescence. An object has obsolesced (or become obsolete) if no one uses it anymore. For instance, a businessperson may own 15 functional typewriters, but even though these items work, they are of little value because the staff requires up-to-date computers to do their jobs. It is important to note that the concept of depreciation does not apply to one-time damage or destruction. An asset is not said to have depreciated if it is destroyed in a fire, a flood, or an accident.

Because objects such as computers and machinery depreciate, businesses lose money on equipment each year. If, for example, a shipping company needs to maintain a fleet of trucks to operate its business, and it purchases a truck for $120,000, that truck may only be worth $110,000 the following year. This means that the company has lost $10,000 on the value of the truck. After 10 years the truck may no longer be serviceable. To help businesses compensate for this loss, the government allows them to claim depreciation as a business expense on tax forms. Because businesses pay taxes on their net profits (the amount of money they have made after subtracting all expenses), claiming depreciation as an expense reduces the net profit and therefore reduces the tax that a business must pay.

When Did It Begin

The first tax law in the United States that allowed businesses to deduct (subtract) an amount for the depreciation of their assets from the taxes they owed the government was the Tariff Act of 1909. Since 1909, tax laws regarding depreciation have changed at least once every decade. These changes often reflect the government’s attitude about the purpose of depreciation. In 1909 Congress voted to institute the new tax law because big business, in order to determine net profit accurately, needed to measure the value of their assets at the end of each year. At that time most corporations did not measure the depreciation of assets in their accounting records. Because of this their yearly net profit measurements were overstated: they were not counting the declining value of their equipment as a financial loss and thus, a business expense. The 1909 tax law was designed to help businesses by reducing their taxes so they would have more money available to maintain their assets and/or to purchase more assets.

From the 1950s through the middle of the 1960s, changes to depreciation tax laws were introduced for another reason: to encourage businesses to reinvest their profits (that is, to put money back into their own company). During this time tax laws permitted corporations to deduct large amounts of money for the depreciation of their assets; they could thus pay less in taxes and then use the money they saved to maintain assets and to expand their businesses. The thinking was that this reinvestment would create more jobs and help the nation’s economy grow.

More Detailed Information

Depreciation is not a cash cost (an amount of money that a business pays out to someone); it is an expense that is logged in company books for a given tax period. Figuring depreciation for tax purposes can become complicated and confusing very quickly. For this reason most business owners hire an accountant to balance their books and calculate the depreciation of business assets. Accountants can use several different methods to chart the declining value of assets. One of the simplest methods is called straight-line depreciation.

To compute the straight-line depreciation of an asset, a business must first determine the asset’s life span and salvage value (the value of what remains when its life span is over). Returning to the example of the shipping company, assume that the new $120,000 truck will last for 10 years. This is the truck’s life span. Next, assume that after 10 years the company will be able to sell the truck for $20,000 to another company that will recycle the vehicle’s parts. This means that the salvage value of the truck is $20,000. Subtracting the salvage value from the original cost shows that in its 10-year life span the truck will depreciate by $100,000. The straight-line method calculates depreciation evenly over those 10 years. In the case of the truck, this would be a depreciation of $10,000 per year, which means that every year the company can deduct $10,000 from its profits. The company can reduce its taxes in this way and keep more money to buy new equipment.

Another option for calculating declining values of assets is called accelerated depreciation. Though computing accelerated depreciation is more complicated, most businesspeople and accountants prefer this method to straight-line depreciation because it allows for larger tax deductions in the early years of owning the new asset. Among the many ways of figuring accelerated depreciation, the declining-balance method is the most common. This method allows a company to deduct as much as twice the amount of the straight-line value in the first year of owning a new asset. The company is permitted to deduct slightly less each succeeding year.

Using the straight-line method, the shipping company deducted $10,000 (or 10 percent of the truck’s total depreciation) from its taxes each year. The declining-balance method allows the company to deduct 20 percent ($20,000) each year in the early part of the life span of the vehicle. The company would not deduct that 20 percent from the fixed figure of $100,000 in those years, however; it would deduct the 20 percent from the depreciated value of the truck. The second year it owned the truck, then, the company would deduct 20 percent of $80,000 ($100,000 minus the $20,000 deducted the previous year), which is $16,000. The third year the company would deduct 20 percent of $64,000, or $12,800. When the deduction for the declining-balance depreciation is less than the straight-line figure ($10,000 in the case of the truck), the company can use the straight-line method for the rest of the life span of the truck.

Recent Trends

Since the 1980s depreciation tax laws in the United States have sought either to increase corporate investment or to reduce the national debt, which includes money that the federal government owes to other countries and to lenders within the United States. Favorable depreciation laws (those permitting businesses to claim high values for depreciation) tend to stimulate corporate investment, while more strict depreciation laws (those that let corporations keep less money for depreciation) raise tax dollars that the government can use to reduce the national debt. In 1981, in an effort to come out of a recession, the U.S. Congress passed the Economic Recovery Tax Act. This law treated depreciation in a new way. Until 1981, laws had kept allowable deductions for depreciation reasonably consistent with the declining value of the product over its useful life. The 1981 law, however, let companies use depreciation as a way to quickly recover the money spent on assets. Corporations were allowed to fully depreciate some assets in as few as three years, regardless of how long the assets were useful. This greatly reduced corporate taxes, thus increasing the amount of money corporations had and could use to expand their businesses. Corporations bought more assets, hired more employees, and requested more loans for long-term projects, such as building new offices and factories. All of this improved the economy. Although the Revenue Reconciliation Act of 1993 required that depreciation deductions accurately reflect the value of assets, in 2000 the government returned to a policy of extending tax benefits to corporations.