depreciation

Related to depreciation: depreciation methods, Accumulated Depreciation, straight line depreciation

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.

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).

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.

depreciation

Depreciation

A non-cash expense (also known as non-cash charge) that provides a source of free cash flow. Amount allocated during the period to amortize the cost of acquiring long-term assets over the useful life of the assets. To be clear, this is an accounting expense not a real expense that demands cash. The sum of depreciation expenses of prior years leads to the balance sheet item Accumulated Depreciation.

Depreciation

The gradual reduction of an asset's value. It is an expense, but because it is non-cash, it is often effectively a tax write-off; that is, a person or company usually may reduce his/her/its taxable income by the amount of the depreciation on the asset. Because there are many different ways to account depreciation, it often bears only a rough resemblance to the asset's useful life. This may further benefit the company as they may continue to use the asset tax-free after its value has technically depreciated to nothing. See also: Amortization.

depreciation

The periodic cost assigned for the reduction in usefulness and value of a long-term tangible asset. Because firms can use several types of depreciation, the amount of depreciation recorded on corporate financial statements may or may not be a good indication of an asset's reduction in value. Depreciation not only affects the asset's value as stated on the balance sheet, it also affects the amount of reported earnings. See also Accelerated Cost Recovery System, accelerated depreciation, accumulated depreciation, recapture of depreciation, straight-line depreciation.

Depreciation.

Certain assets, such as buildings and equipment, depreciate, or decline in value, over time.

You can amortize, or write off, the cost of such an asset over its estimated useful life, thereby reducing your taxable income without reducing the cash you have on hand.

Fig. 33 Depreciation. Two methods of calculating depreciation.

depreciation

amortization

the fall in the value of an ASSET during the course of its working life. The condition of plant and equipment used in production deteriorates over time and these items will eventually have to be replaced. Accordingly, a firm needs to make financial provision for the depreciation of its assets.
Depreciation is an accounting means of dividing up the HISTORIC COST of a FIXED ASSET over a number of accounting periods which correspond with the asset's estimated life. The depreciation charged against the revenue of successive time periods in the PROFIT-AND-LOSS ACCOUNT serves to spread the original cost of a fixed asset yielding benefit to the firm over several trading periods. In the period-end BALANCE SHEET such an asset would be included at its net book value (cost less cumulative depreciation deducted to date). This depreciation charge does not attempt to calculate the reducing market value of fixed assets, so that balance sheets do not show realization values.

Different formulas used to calculate depreciation can lead to variations in the balance sheet value of a fixed asset and in the charge against GROSS PROFIT for depreciation. The second formula in Fig. 33 gives a large depreciation charge in the early periods of the fixed asset's life and a small charge in the later years (accelerated depreciation). In the interests of consistency, firms generally do not change the depreciation formula used for their fixed assets but stick to the same formula indefinitely.

All these depreciation formulas base the depreciation charge on the historic cost of fixed assets. However, during a period of INFLATION it is likely that the REPLACEMENT COST of an asset is likely to be higher than its original cost. Therefore, prudent companies need to make PROVISION for higher replacement costs in the form of a REVALUATION RESERVE. See INFLATION ACCOUNTING, CAPITAL CONSUMPTION, APPRECIATION, CREATIVE ACCOUNTING.
a decrease in the EXCHANGE RATE of a currency against other currencies under a FLOATING EXCHANGE RATE SYSTEM, reflecting a fall in market demand for that currency combined with a rise in market demand for other countries' currencies. The effect of a depreciation is to make imports (in the local currency) more expensive and exports (in the local currency) cheaper, thereby assisting in the removal of a BALANCE OF PAYMENTS deficit by acting to reduce import demand for goods and services and increasing export demand.
Depreciations, like DEVALUATION, provide firms with an opportunity to expand sales and boost profitability by improving their price competitiveness in both home and export markets. See DEVALUATION for further discussion. Contrast with APPRECIATION, definition 2. See EXCHANGE RATE EXPOSURE.

Fig. 43 Depreciation. (a) A depreciation of the pound against the dollar. (b) The effect of depreciation on export and import prices.

depreciation

INTEREST is payable on deposit accounts, normally at rates above those paid on current accounts, in order to encourage clients to deposit money for longer periods of time. Unlike with a current account, cheques cannot generally be drawn against deposit accounts. See BANK DEPOSIT.

a fall in the value of a CURRENCY against other currencies under a FLOATING EXCHANGE-RATE SYSTEM, as shown in Fig. 43 (a). A depreciation of a currency's value makes IMPORTS (in the local currency) more expensive and EXPORTS (in the local currency) cheaper, thereby reducing imports and increasing exports, and so assisting in the removal of a BALANCE OF PAYMENTS deficit. For example, as shown in Fig. 43 (b), if the pound-dollar exchange rate depreciates from £1.60 to £1.40, then this would allow British exporters to reduce their prices by a similar amount, thus increasing their price competitiveness in the American market (although they may choose not to reduce their prices by the full amount of the depreciation in order to boost profitability or devote more funds to sales promotion, etc.) By the same token, the depreciation serves to raise the sterling price of American products imported into Britain, thereby making them less price-competitive than British products in the home market. In order for a currency depreciation to ‘work’, four basic conditions must be satisfied:
1. how successful the depreciation is depends on the reactions of export and import volumes to the change in relative prices, i.e. the PRICE ELASTICITY OF DEMAND for exports and imports. If these volumes are low, i.e. demand is inelastic, trade volumes will not change much and the depreciation may in fact worsen the situation. On the other hand, if export and import demand is elastic then the change in trade volume will improve the payments position. Balance-of-payments equilibrium will be restored if the sum of export and import elasticities is greater than unity (the MARSHALL-LERNER CONDITION);
2. on the supply side, resources must be available, and sufficiently mobile, to be switched from other sectors of the economy into industries producing exports and products that will substitute for imports. If the economy is fully employed already, domestic demand will have to be reduced and/or switched by deflationary policies to accommodate the required resource transference;
3. over the longer term, ‘offsetting’ domestic price, rises must be contained. A depreciation increases the cost of essential imports of raw materials and foodstuffs, which can push up domestic manufacturing costs and the cost of living. This in turn can serve to increase domestic prices and money wages, thereby necessitating further depreciations to maintain price competitiveness;
4. finally, a crucial requirement in underpinning the ‘success’ of the above factors and in maintaining long-run equilibrium is for there to be a real improvement in the country's industrial efficiency and international competitiveness. (See ADJUSTMENT MECHANISM entry for further discussion.) See BALANCE-OF-PAYMENTS EQUILIBRIUM, INTERNAL-EXTERNAL BALANCE MODEL, PRICE ELASTICITY OF SUPPLY.
Compare APPRECIATION 1.
the fall in the value of an ASSET during the course of its working life. Also called amortization. The condition of plant and equipment used in production deteriorates over time, and these items will eventually have to be replaced. Accordingly, a firm is required to make financial provision for the depreciation of its assets.

Depreciation is an accounting means of dividing up the historic cost of a FIXED ASSET over a number of accounting periods that correspond with the asset's estimated life. The depreciation charged against the revenue of successive time periods in the PROFIT-AND-LOSS ACCOUNT serves to spread the original cost of a fixed asset, which yields benefits to the firm over several trading periods. In the period end BALANCE SHEET, such an asset would be included at its cost less depreciation deducted to date. This depreciation charge does not attempt to calculate the reducing market value of fixed assets, so that balance sheets do not show realization values.

Depreciation formulas base the depreciation charge on the HISTORIC COST of fixed assets. During a period of INFLATION, however, it is likely that the REPLACEMENT COST of an asset is likely to be higher than its original cost. Thus, prudent companies need to make provision for higher replacement costs of fixed assets. See INFLATION ACCOUNTING, CAPITAL CONSUMPTION, APPRECIATION ?.

depreciation

(1) In accounting, the process of deducting some portion of the acquisition cost of property over time,as an expense against income,to reflect the fact that the property is becoming less valuable and will eventually require replacement. One cannot allow a $3,000,000 building to remain on the books for 35 years as an asset at the same value and then,suddenly one year,demol-
ish the building, write off $3,000,000 against income for that particular year, and then construct another building or move. (2) In appraisal, a reduction in the calculations for the reproduction cost of an improvement, in order to arrive at a value of the improvement in its current state, not as it would be if it were reproduced and brand new.

Depreciation

Depreciation is the deduction for the reasonable allowance for the wear and tear of assets with a life of more than one year, including real estate but not inventory, used in a trade or business or held for the production of income.

depreciation

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Cross-references

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Depreciation.

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amortization

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Synonyms for depreciation

noun devaluation

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Synonyms for depreciation

noun a lowering in price or value

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noun the act or an instance of belittling

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Synonyms for depreciation

noun a decrease in price or value

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Antonyms

noun decrease in value of an asset due to obsolescence or use

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noun a communication that belittles somebody or something

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