Depreciation is the means of spreading out the price of a usable physical asset during the period of its practical life. Businesses engage in this process of depreciating assets for accounting and taxing purposes. Depreciation can also be the reduction of the value of an asset that poor market conditions create.
Where accounting and taxing purposes are concerned, the process of depreciation demonstrates the portion of the value of the asset in question that has been utilized. Where taxes are concerned, the rules are stricter. The IRS sets out the regulations for taking depreciation of tangible assets.
Businesses are permitted to deduct the expenses of the asset they buy as a business expense. They simply must abide by the IRS’ rules as far as when and how much of the deduction they are permitted to log. This all comes down to which category the asset falls in and the amount of time for which it is expected to last.
In accounting, businesses attempt to correlate the cost of a particular asset with the amount of income that it practically earns the company. With regards to an item of equipment that costs them $1 million, it may have a practical life expectancy of 10 years. They would depreciate this asset over the course of ten years. The company would then expense out $100,000 of the asset value each accounting year. They would match up the income that the equipment generated the company every year as well.
Accountants can use depreciation tricks to impact the company’s financial bottom line. This is because with enough depreciation, the income statement, cash flow statement, balance sheet, and statement of the owners’ equity will all be impacted significantly. It is true that certain depreciation assumptions can have significant impacts on both the long term asset values and the results of short term earnings.
Other assets can see their value depreciated by unfortunate circumstances or poor conditions in the market. Two standout examples of this type include real estate and currencies. In the housing crisis of 2008, many home owners living in the most severely impacted markets like Las Vegas watched helplessly as their home values depreciated by even 50% of the value. The post Brexit vote results day saw the British pound plunge by over 10% in a single day.
Generally accepted accounting principles affect depreciation figures. This is because a company might pay for a long life asset in cash, as with a tractor trailer that delivers its goods to customers. According to GAAP principles though, this expense would not be shown as a cost against income then and there. Rather than this, the expense is listed as an asset on the company balance sheet. The value of the asset is consistently and continuously reduced out during the in-service life of the asset in question. As the expense is reduced, this is a form of depreciating the asset.
This is done because GAAP principles insist that all expenses must be recorded along with the accounting time-frame as are the revenues which they generate. In the example of the tractor trailer that costs $100,000 and lasts for approximately ten years, GAAP would look to see what the salvage value would be at the end of that time. Assuming it expected the trailer to be worth $10,000 at the end of the depreciating period, than the expense would be depreciated at a rate of $9,000 for each of the ten years (using the formula of cost – salvage value/number of years depreciating).
With long term assets, the depreciating typically involves two lines. There would commonly be one that displayed the price of the assets and another that demonstrated the amount of depreciating that had been charged off against the assets’ value.