Depreciation is an accounting practice used to spread the cost of a tangible or physical asset over its useful life. Depreciation represents how much of the asset’s value has been used up in any given time period. Companies depreciate assets for both tax and accounting purposes and have several different methods to choose from.
A depreciating asset is an asset that has a limited effective life and can reasonably be expected to decline in value over the time it is used. Depreciating assets include such items as computers, electric tools, furniture and motor vehicles.
Land and items of trading stock are specifically excluded from the definition of depreciating asset.
Most intangible assets are also excluded from the definition of depreciating asset. Only the following intangible assets, if they are not trading stock, are specifically included as depreciating assets:
- in-house software; see In-house software
- certain items of intellectual property (patents, registered designs, copyrights and licences of these)
- mining, quarrying or prospecting rights and information
- certain indefeasible rights to use a telecommunications cable system
- certain telecommunications site access rights, and
- spectrum licences.
Improvements to land or fixtures on land (for example, windmills and fences) may be depreciating assets and are treated as separate from the land, regardless of whether they can be removed or not.
What Is a Depreciated Asset?
A fully depreciated asset is a property, plant or piece of equipment (PP&E) which, for accounting purposes, is worth only its salvage value. Whenever an asset is capitalized, its cost is depreciated over several years according to a depreciation schedule. Theoretically, this provides a more accurate estimate of the true expenses of maintaining the company’s operations each year.
An asset can reach full depreciation when its useful life expires or if an impairment charge is incurred against the original cost, though this is less common. If a company takes a full impairment charge against the asset, the asset immediately becomes fully depreciated, leaving only its salvage value (also known as terminal value or residual value). The depreciation method can take the form of straight-line or accelerated (double-declining-balance or sum-of-year), and when accumulated depreciation matches the original cost, the asset is now fully depreciated on the company’s books.
In reality, it is difficult to predict the useful life of an asset, so depreciation expenses represent only a rough estimate of the true amount of an asset used up each year. Conservative accounting practices dictate that when in doubt, it is more prudent to use a faster depreciation schedule so that expenses are recognized earlier. In that way, if the asset does not live out the expected life, the company does not incur an unexpected accounting loss.
Types of Depreciation
- Straight-Line- The straight-line method is the most basic way to record depreciation. It reports an equal depreciation expense each year throughout the entire useful life of the asset until the asset is depreciated down to its salvage value.
Declining Balance- The declining balance method is an accelerated depreciation method that begins with the asset’s book, rather than salvage, value. Because an asset’s carrying value is higher in earlier years (before it has begun to be depreciated), the same percentage causes a larger depreciation expense amount in earlier years,
Double-Declining Balance (DDB)- The double-declining balance (DDB) method is an even more accelerated depreciation method. It doubles the (1/Useful Life) multiplier, making it essentially twice as fast as the declining balance method.
Sum-of-the-Years’ Digits (SYD)– The sum-of-the-years’ digits (SYD) method also allows for accelerated depreciation. You start by combining all the digits of the expected life of the asset.
FAQs
How Do Businesses Determine Salvage Value?
Salvage value can be based on past history of similar assets, a professional appraisal, or a percentage estimate of the value of the asset at the end of its useful life.
What Is Depreciation Recapture?
Depreciation recapture is a provision of the tax law that requires businesses or individuals that make a profit in selling an asset that they have previously depreciated to report it as income. In effect, the amount of money they claimed in depreciation is subtracted from the cost basis they use to determine their gain in the transaction. Recapture can be common in real estate transactions where a property that has been depreciated for tax purposes, such as an apartment building, has gained in value over time.
How Does Depreciation Differ From Amortization?
Depreciation refers only to physical assets or property. Amortization essentially depreciates intangible assets, such as intellectual property like trademarks or patents, over time.
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