Define Depreciation Accounting
Most companies use fixed assets in the course of their business. Fixed assets are large-ticket items that are useful over a several-year period. Because of the high dollar value to acquire these assets and their long-term usefulness, these items are not expensed when they are acquired. Instead a portion of the cost is expensed each period through a process called depreciation. There are several methods from which companies may choose to use to depreciate their assets.
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Estimates
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When a company first acquires a fixed asset, they know the cost of their investment right away. However, there are some pieces of information they do not know. These are the estimated salvage value at the time they dispose of the equipment, or the number of years the equipment will last. They must make estimates of these two key pieces of information prior to calculating depreciation.
Straight Line
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Straight line depreciation is commonly used because of its simple calculation. To calculate straight line depreciation, the estimated salvage value is subtracted from the total cost of the investment. This amount is then called the depreciable basis. The depreciable basis is then divided among the total periods of the estimated useful life of the asset. This is the amount of depreciation expense to be recognized each period.
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Units of Production
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Units of production depreciation is also a simple calculation. The life of the equipment is measured in total units to be produced rather than in number of years. The estimated salvage value is subtracted from the total cost of the investment to determine the depreciable basis. The depreciable basis is then divided among the total estimated units of production. At the end of each period, the number of units produced is multiplied by this amount. This is the amount of depreciation expense to be recognized.
Accelerated Methods
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Some companies would like to recognize a higher level of depreciation in the early years of acquiring the asset. This is especially true in circumstances where an asset will lose more of its value in the early years, such as technological assets. The calculations are more complex than the straight line or units of production. These methods include double declining balance and sum of the year's digits.
Tax Depreciation
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The Internal Revenue Service (IRS) sets forth specific requirements in order to claim depreciation expense on a company or individual's tax return. At a minimum, the property must be owned by the taxpayer, be used for income and have an estimated useful life of more than a year. The IRS has its own Modified Accelerated Cost Recovery System, which is an accelerated depreciation method used for tax purposes.
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References
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