About Depreciation

"Depreciation" is a term used in business to refer to the reduction in value of an asset because of regular usage, usual wear and tear, obsolescence caused by new technology or other factors that devalue an asset during its life span. The two most common methods of depreciation are the straight-line depreciation method and accelerated methods, such as the double-declining-balance method.

Identification

Depreciation is used in accounting to spread out the initial or purchase price of an asset over the time period the asset is used to make sure assets are valued correctly regarding balancing revenues and expenses.
In economics, depreciation is used to recognize the decrease in value of a company because of the attrition and/or erosion of resources over the years.

Significance

Depreciation affects the financial statements of companies, thus changing the amount of taxes paid by companies and individuals. Section 167 of the Internal Revenue Code states that companies are allowed a "depreciation deduction for the exhaustion, wear and tear, and obsolescence of property used in the trade or business or held for the production of income."
Knowing the value of different depreciation methods is critical, because the method chosen can change depreciation expenses and taxable profits for a company.

Methods

The most commonly used method of depreciation is straight-line depreciation, which is calculated by taking the original cost of the asset and subtracting the scrap value to determine the net value after the years of use. The scrap value, also called salvage value, is the amount expected from the sale of the asset. The net value is then divided by the years the asset was used to find the annual depreciation expense.
A more realistic method of depreciation is the double-declining-balance method, which takes into account accelerated depreciation. With most assets, more rapid depreciation occurs at the beginning of the useful life rather than it being spread out equally over a number of years. As the name suggests, the double-declining-balance method uses twice the depreciation rate of straight-line depreciation.

Considerations

The loss in the value of an asset can be represented differently in different areas of business. Since depreciation affects both the financial statements and taxable profits of a company, it is widely accepted that the depreciation expenses usually differ between accounting records and tax records. Most companies prefer an accelerated depreciation method for tax records because the larger depreciation expense in earlier years decreases the amount of taxable profit.

Warning

There are certain rules and requirements to follow when using depreciation for tax purposes; auditors are in charge of overlooking these regulations. With only two types of depreciation allowed for tax purposes, the auditors' most important job is to make sure assumptions and estimates made by the company, especially about the scrap or the salvage value of assets, is reasonable. For example, some common assets, such as property, have a standard minimum requirement of a useful life of 20 years; other requirements vary depending on the type of asset.