It is a method of reallocating the cost of a tangible asset over its useful life span of it being in motion. The former affects the balance sheet of a business or entity, and the latter affects the net income that they report. Generally the cost is allocated, as depreciation expense, among the periods in which the asset is expected to be used.
Methods of computing depreciation, and the periods over which assets are depreciated, may vary between asset types within the same business and may vary for tax purposes. These may be specified by law or accounting standards, which may vary by country. There are several standard methods of computing depreciation expense, including fixed percentage, straight line, and declining balance methods.
Depreciation expense generally begins when the asset is placed in service. For example, a depreciation expense of 100 per year for five years may be recognized for an asset costing 500. It has been defined as the diminution in the utility or value of an asset. It is a non cash expense. It does not result in any cash outflow. Causes of depreciation are natural wear and tear.
Businesses depreciate long-term assets for both tax and accounting purposes. For tax purposes, businesses can deduct the cost of the tangible assets they purchase as business expenses; however, businesses must depreciate these assets according to IRS rules about how and when the company can take the deduction.
It is often a difficult concept for accounting students as it does not represent real cash flow. .
In determining the profits (net income) from an activity, the receipts from the activity must be reduced by appropriate costs. One such cost is the cost of assets used but not immediately consumed in the activity. Such cost so allocated in a given period is equal to the reduction in the value placed on the asset, which is initially equal to the amount paid for the asset and subsequently may or may not be related to the amount expected to be received upon its disposal.
Depreciation is any method of allocating such net cost to those periods in which the organization is expected to benefit from use of the asset. The asset is referred to as a depreciable asset. It is technically a method of allocation, not valuation, even though it determines the value placed on the asset in the balance sheet.
Any business or income producing activity using tangible assets may incur costs related to those assets. If an asset is expected to produce a benefit in future periods, some of these costs must be deferred rather than treated as a current expense. The business then records depreciation expense in its financial reporting as the current period’s allocation of such costs. This is usually done in a rational and systematic manner. Generally this involves four criteria:
– Cost of the asset
– Expected salvage value, also known as residual value of the assets
– Estimated useful life of the asset
– A method of apportioning the cost over such life
While depreciation expense is recorded on the income statement of a business, its impact is generally recorded in a separate account and disclosed on the balance sheet as accumulated depreciation, under fixed assets, according to most accounting principles. Accumulated depreciation is known as a contra account, because it separately shows a negative amount that is directly associated with another account.
Without an accumulated depreciation account on the balance sheet, depreciation expense is usually charged against the relevant asset directly. The values of the fixed assets stated on the balance sheet will decline, even if the business has not invested in or disposed of any assets. The amounts will roughly approximate fair value. Otherwise, depreciation expense is charged against accumulated depreciation. Showing accumulated depreciation separately on the balance sheet has the effect of preserving the historical cost of assets on the balance sheet. If there have been no investments or dispositions in fixed assets for the year, then the values of the assets will be the same on the balance sheet for the current and prior year (P/Y).
Many tax systems prescribe longer depreciable lives for buildings and land improvements. Such lives may vary by type of use. Many such systems, including the United States and Canada, permit depreciation for real property using only the straight line method, or a small fixed percentage of cost. Generally, no depreciation tax deduction is allowed for bare land. In the United States, residential rental buildings are depreciable over a 27.5 year or 40 year life, other buildings over a 39 or 40 year life, and land improvements over a 15 or 20 year life, all using the straight line method.
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