Depreciation of Capital
Capital is the lifeblood of most manufacturing firms. It includes facilities, property, equipment and liquid assets. Purchases of capital can be deducted from revenues to reduce net income for tax purposes. However, only a portion of the capital purchased can be written off. This smaller write down is referred to as depreciation. It may take 30 years to completely write off the value of capital equipment through depreciation.
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Capitalized Assets
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Depreciation is a noncash expense. It is used as a way to estimate the value of used assets over time due to wear and tear. It is also used as a way to write off the value of assets over time. Because capital equipment is used over a period of years, it is capitalized, which means that only a portion of the expense associated with purchasing the asset can be deducted from net income in the current year.
Straight Line Method
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The portion of the asset cost that can be written off is referred to as depreciation expense. The most commonly used method to calculate depreciation is referred to as the straight line method. The straight line method subtracts the salvage value of the asset from the cost of the asset and then divides the answer by the number of years the asset is expected to generate revenue.
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Tax Liability
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Assume the cost of equipment with a useful life of five years is $30,000. According to the salvage yard, its salvage value is $5,000. The depreciation expense is calculated by subtracting $5,000 from $30,000 and then dividing by five. The answer is $5,000, which is the annual depreciation expense. Every year $5,000 is deducted from net income, which lowers the tax liability.
Matching Principle
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The IRS taxes companies based on net income. The calculation of net income on the income statement attempts to make an estimate for what that net income is. Depreciation is an estimate for asset usage. Accounting policy likes to match revenues with expenses. Capital with a useful life of more than one year uses an estimate of annual depreciation to better match future revenues with future costs.
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