"Depreciation" literally means the lowering of the value of something—and specifically of fixed or capital assets. In accounting terminology the word refers to an entry on the balance sheet which records the amount of money deducted from total assets because the assets have aged. All capital assets are subject to depreciation except land. The current year's depreciation of capital assets may be deducted from income for tax purposes. A business purchasing a van for deliveries must put the acquisition cost of the van, say $36,000, on its books as a capital asset. Tax law permits depreciation of the van over five years. Using a straight-line method of depreciation, the annual depreciation of the van would be $7,200. In actuality the small business may handle depreciation in another way under current tax law, to be discussed below, but this example illustrates the concept. The annual depreciation of $7,200 is treated as a cost, deductible from profits, and therefore it reduces income taxes.
The traditional treatment of capital assets—their depreciation over a number of years—is based on the simple fact that buildings, machinery, vehicles, roads, and other improvements of this type have a life of multiple years. In theory they are paid for from savings accumulated over multiple years and are depreciated (written off) over their useful life. Land is not depreciated because it never wears out. Bookkeeping is aimed at accurately reflecting on-going operations—in the current year. For this reason capital inflows are not reflected in income and depreciation is spread out over the life of the asset.
THE BALANCE SHEET PERSPECTIVE
Company balance sheets are divided into Assets and Liabilities. On the Asset side, the ledger shows current and fixed assets. Fixed Assets are subdivided into such categories as Vehicles, Furniture and Fixtures, Equipment, and Buildings. As such assets are acquired, their actual costs of acquisition are entered under these categories. Each of these categories, however, is followed by a line which says: "Less: Accumulated Depreciation." Each year a portion of the asset is added to the depreciation line. The net of these two values (acquisition costs less accumulated depreciation) is what is counted as "fixed assets." The role of depreciation in the accounting sense, therefore, is to keep the books honest: only the actualremaining value of fixed assets is counted on the books.
Accountants calculate how much of each category of assets to depreciate every year by using Generally Accepted Accounting Principles (GAAP) established by Financial Accounting Standards Board. Within a single category, such as buildings, for instance, the life of a structure may vary from 10 years for a tool shed to 80 years for fire-resistant bearing walls, beams, decks, and floors. The acquisition cost is divided by the appropriate number of years. Very complex schedules are used to determine "life."
THE TAX PERSPECTIVE
Depreciation is treated as a cost category in tax calculations. It is not a "cash cost" because no actual disbursement of cash takes place; depreciation is simply an entry in the books. But for tax purposes depreciation has a "cash consequence": it reduces the actual tax liability of a company. From a tax perspective, therefore, any law that permits higher deductions of depreciation than accounting principles specify are favorable for the corporation: no cash payment is involved in so-called "accelerated depreciation" but real cash benefits result: lower taxes.
Letting companies speed up depreciation has, for this reason, become a popular technique of lowering taxes and thus, by giving more money to companies, stimulating the economy. Regulating depreciation in the tax code is also a relatively precise instrument. Congress can aim its policy at certain categories of expenditures. It can, for instance, stimulate purchases of vehicles by letting businesses write them off more quickly; or it can favor a broad category such as computers. Congress has done both. It could also, at its discretion, stimulate industrial construction, for instance, by letting companies write off buildings or land improvements quickly.
In the example presented at the beginning, for instance—the $36,000 van—under the rules in force during the 2004 tax year, a small business could write off a substantial portion of that van ($24,000) in the year of acquisition, the remainder over five years. In these situations a maximum cap usually applies. In 2004 tax years, for example, the cap was $102,000.
CASH FLOW CALCULATION
Businesses calculate the cash flow of their business—usually in the context of justifying loans. Cash flow is simply the netting out, for a given period (a quarter, a year, multiple years) of all cash coming in from sales and cash flowing out for purchases and payments on debt and interest. In this context, however, depreciation is often mentioned as part of the cash flow calculation: depreciation is said to be "added back." The phrasing produces confusion. Cash flow calculations are often automated so that all current income and current costs are cumulated; costs are then deducted from income to derive the cash flow. But in this process some costs are not cash costs. Depreciation is one of those. Therefore, to get an accurate cash flow, depreciation must be added back in because it was not a cash cost in the first place.
ALTERNATIVE METHODS USED
Depreciation may be calculated in a variety of ways all of which are specified in law and elaborated in the Generally Accepted Accounting Principles. Major categories are 1) the straight-line method, 2) units-of-production method, 3) declining-balance method, and 4) sum-of-the-years-digits method.
The residual (salvage) value of the asset is first estimated. Thereafter the asset, minus salvage value, is divided by the useful life of the asset. The resulting value is deducted for each year of the asset's life.
This method is used when the usage of the asset varies from year to year and its use can be determined by some measure such as miles driven, tonnage hauled, cuts made, etc. Again, salvage value is deducted. Next, the remaining value is divided by the total units the asset is estimated to be able to produce. Units produced are recorded for every year. Depreciation for each year is calculated based on the units. Thus depreciation may be very high one year, low in another year—until the total count of units has been used up.
This method, also known as double-declining-balance, is an accelerated method of depreciation because depreciation is highest in the first year and then declines with each year. The formula requires dividing 2 by the years of life to get a percentage and then applying that percentage to the balance of the asset. Assuming a three-year life for a $5,000 asset, the first year of depreciation will be 5,000 × (2/3) = $3,333. The asset is then reduced by that amount and becomes $1,667. The second year, the depreciation is 1,667 × (2/3) or .66667 = $1,111. Again, the asset is reduced by that amount, leaving $556. The procedure is repeated again. Under this method, however, the asset may not be depreciated below its salvage value; for this reason, the third year operation may not be possible.
Supposing that the life of an asset is five years. In that case the sum of the year's digits will be 1+2+3+4+5 = 15. The asset value less its salvage value is calculated. Let us assume that the result is $8,750. In the first year the net asset value will be multiplied by the fraction 5/15 (0.333), in the second by 4/15 (0.2667), in the third by 3/15 (0.2), and so on, yielding depreciations streams of $2,914, $2,333, $1,750, and son on. After five years, the total depreciation streams will sum to $8,750.
It is worthwhile to know about such fascinating things as sum-of-the-years-digits, but most small business owners have better things to do. Those with substantial fixed assets typically seek the advise of a certified public accountant (CPA) and profit by his or her professional experience. In the mid-2000s, when government appeared intent on cutting taxes first and then asking questions later—and the environment was favorable to small business, seen as the only generator of new jobs—substantial tax savings and incentives to invest were available in an ever changing tax code to which the CPA was an invaluable guide.
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Cummings, Jack. "Depreciation Is Out of Favor, But It Matters." Triangle Business Journal. 25 February 2000.
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O'Bannon, Isaac M. "Fixed Assets Software Replaces Duct Tape Spreadsheets." The CPA Technology Advisor. December 2005.
Russ, Don. "Real Estate Depreciation: Be aware of the details." San Fernando Valley Business Journal. 12 September 2005.
Whitson, Alan. "Depreciation Without the Headache." Fairfield County Business Journal. 19 December 2005.
Vorster, Mike. "Let's Sideline Straight-Line Depreciation." Construction. 1 October 2005.
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.
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.
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.
Hudson, David M., and Stephen A. Lind. 1994. Federal Income Taxation. 5th ed. St. Paul, Minn.: West.
Economists use the term depreciation to refer to the loss of economic value suffered by business assets and equipment, consumer goods, and currency as time passes. The most common use of depreciation in economics is in business tax law. The Internal Revenue Service (IRS) allows businesses to lower the amount of taxes they owe by counting as a business expense the total depreciation of aging equipment and assets over the previous year. For example, if a business bought a photocopier in March, by December it will have declined in value by some amount. To claim this depreciation in value as an expense, the business must first determine the average "life span" of the photocopier, so it will know what percentage of the photocopier's total value has eroded in the past year. The two most common methods for determining how much assets have depreciated were the "straight-line" method and the "declining-balance" or "declining-charge" method.
During World War II (1939–1945), the U.S. government began to allow businesses to "accelerate" the depreciating value of their assets. For example, rather than telling businesses that typewriters had a "life span" of seven years, the IRS allowed businesses to claim that typewriters had a useful life of, say, five years. This meant that businesses could enjoy the tax savings they gained from the declining value of their typewriters in five years rather seven. Speeding up the depreciation of a company's assets in this way gave businesses more money in the short term to invest in expansion and new equipment. Among the first legislation of President Ronald Reagan's (1981–1989) administration was the Economic Recovery Tax Act of 1981, which attempted to encourage companies to expand by shortening the standard five-year depreciation for business assets to three years.
The term depreciation also referred to the decline in value of one currency against another. If one U.S. dollar bought 1.5 German marks one year but only 1.4 marks the next year, the dollar "depreciated" against the mark.
See also: Appreciation
de·pre·ci·ate / diˈprēshēˌāt/ • v. 1. [intr.] diminish in value over a period of time: the pound is expected to depreciate against the dollar. ∎ reduce the recorded value in a company's books of (an asset) each year over a predetermined period: the computers would be depreciated at 50 percent per annum. 2. [tr.] disparage or belittle (something): she was already depreciating her own aesthetic taste. DERIVATIVES: de·pre·ci·a·to·ry / -shēəˌtôrē/ adj.
de·pre·ci·a·tion / diˌprēshēˈāshən/ • n. a reduction in the value of an asset with the passage of time, due in particular to wear and tear. ∎ decrease in the value of a currency relative to other currencies: depreciation leads to losses for nondollar-based investors | a currency depreciation.