depreciation

Gen Mgt

an allocation of the cost of an asset over a period of time for accounting and tax purposes. Depreciation is charged against earnings, on the basis that the use of capital assets is a legitimate cost of doing business. Depreciation is also a noncash expense that is added into net income to determine cash-flow in a given accounting period.

EXAMPLE

To qualify for depreciation, assets must be items used in the business that wear out, become obsolete, or lose value over time from natural causes or circumstances, and they must have a useful life beyond a single tax year. Examples include vehicles, machines equipment, furnishings, and buildings, plus major additions or improvements to such assets. Some intangible assets also can be included under certain conditions. Land, personal assets, stock, leased or rented property, and a company’s employees cannot be depreciated.

     Straight-line depreciation is the most straightforward method. It assumes that the net cost of an asset should be written off in equal amounts over its life. The formula used is:

(Original cost – scrap value)/Useful life (years)

For example, if a vehicle cost $20,000 and can be expected to serve the business for seven years, its original cost would be divided by its useful life:

(30,000 – 2,000)/7 = 4,000 per year

The $4,000 becomes a depreciation expense that is reported on the company’s year-end income statement under “operation expenses.”

     In theory, an asset should be depreciated over the actual number of years that it will be used, according to its actual drop in value each year. At the end of each year, all the depreciation claimed to date is subtracted from its cost in order to arrive at its book value, which would equal its market value. At the end of its useful business life, any undepreciated portion would represent the salvage value for which it could be sold or scrapped.

     For tax purposes, some accountants prefer to use accelerated depreciation to record larger amounts of depreciation in the asset’s early years in order to reduce tax bills as soon as possible. In contrast to the straight-line method, the declining-balance method assumes that the asset depreciates more in its earlier years of use. The table opposite compares the depreciation amounts that would be available, under these two methods, for a $1,000 asset that is expected to be used for five years and then sold for $100 in scrap.

     The depreciation method to be used for a particular asset is fixed at the time that the asset is first placed in service. Whatever rules

or tables are in effect for that year must be followed as long as the asset is owned.

     Depreciation laws and regulations change frequently over the years as a result of government policy changes, so a company owning property over a long period may have to use several different depreciation methods.