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Depreciation, as defined by Hotelling (p.340), refers to the decrease in asset value due to use resulting from wear and tear. In accounting, depreciation is measured to assess the asset value during the useful life of the asset. The concept (depreciation) is considered as part of income tax that allows business to recover the cost of assets purchased for use in the company. Depreciation is usually reported for accounting purposes to ensure that financial statements developed have accurate information on the investment of the fixed assets.
How to apply depreciation in business
Depreciation is applied in business in two main ways which include use as a tax deduction strategy and as an expense which is recorded in the financial statement for accounting purposes. To account for investment in fixed assets, businesses have to take into account the depreciating value of the fixed assets over the lifetime of the of the assets. The value obtained is considered as an allowable tax deduction which is obtained using three main approaches.
MACRS (Modified Accelerated Cost Recovery System)/declining balance
It is one of the approaches used and is considered as the primary technique of evaluating depreciation. The method allows businesses to write off more depreciation on the fixed assets during the initial years of the asset and less during the subsequent period.
The approach is preferred by most businesses as it enables firms to write off their assets faster as compared to the other methods. Besides, it is appreciated for the tax shield that it offers to organizations (Swiren p.662).
Straight line depreciation
Straight line depreciation used for products such as patent and computer software hence not applicable to all types of assets. It is the most common approach used in determining capital cost allowance for a fixed asset. The method takes the acquisition costs of a product less its salvage value and divides the amount by the total productive years of the asset (Zeff p.56). The salvage value indicates the amount of cash the business will be willing to dispose of the asset if they no longer need it.
Section 179 deduction
This is used for specific products that fall in the classification of section 179 and allows businesses to deduct taxes up to a maximum of $500,000 during the year of purchase. The technique enables the company to receive all the tax upfront, and thus business does not have to spread the deduction over the years. Example of products that qualify to be classified under section 179 includes business appliances, office equipment, office furniture, business vehicles, software and manufacturing equipment, and tools.
It is important to note that the total amount of depreciation charged on an asset is usually same irrespective of the approach used in its determination. However, techniques embraced in the process influence the amount of depreciation expense that is subjected in each year of the asset’s life thus benefiting firms with a substantial tax burden as less income is reflected on the income statements.
However, it is important to note that the following attributes have to be met for an asset to be considered a depreciable asset.
- The asset must be depreciable – that is, reduce in asset value during its use over the years.
- The asset must be owned by the individual claiming to be compensated for depreciation.
- The fixed assets must also be used in the business of the person depreciating the asset. However, it is essential to acknowledge that an individual can depreciate an asset that is used for both personal and business duties. However, the amount allowed will be limited to the amount time spent on doing personal uses.
- The fixed asset has to have a predetermined useful life meaning that the property has to wear out completely at the end of its useful period.
- Finally, the useful life of the asset must be at least one year.
Benefits of Depreciation and how to Compute
Various benefits are associated with depreciation and include the following;
This is one of the benefits of depreciation and is considered to help firms to give the precise amount of expense incurred during the period that the asset is put into use to match the results with revenue generated (Way Para 2). The process helps business to avoid overstating expenses which may mislead in the financial reporting, hence ruin the sustainability of the business.
This is another benefit of depreciation that enables firms to engage in accurate reporting of an asset in the organization’s book value. Initial recording done by companies states the acquisition price; however, assets depreciate due to wear and tear hence the need to update through asset valuation. Through the process, firms can adjust the value of the assets in the book by subtracting the total depreciation expense.
Through depreciation, firms can generate tax savings, an aspect that enhances the firms’ profitability. Besides, the tax rules account for depreciation expense when evaluating taxable income of business proceedings. Therefore, when firms experience a high depreciation expense, they tend to incur less taxable income, an aspect that results in more tax savings.
The concept (depreciation expense) allows firms to recover cost incurred through the initial purchase of an asset (Way Para 4). The cost is recovered through the annual depreciation expense that is deducted from the generated income subjected to taxation. Therefore, businesses are allowed to set aside part of their revenue to cater for future replacement of the acquired assets.
Depreciation, as indicated in the paper, is considered as a tax and accounting technique which is utilized to account for fixed assets wear and tear. The concept enables firms to take into account the slow degradation of acquired assets through wear and tear, which is experienced during the productive life of an asset. Furthermore, it is imperative to note that different approaches can be used to compute depreciation. However, irrespective of the method used, firms will always obtain the same value of depreciation expense. However, the method used has a different impact on business performance, hence the need for businesses to choose appropriate method during the process.
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- Hotelling, Harold. “A general mathematical theory of depreciation.” Journal of the American Statistical Association 20.151 (1925): 340-353.
- Swiren, Max. “Accelerated Depreciation Tax Benefits in Utility Rate Making.” The University of Chicago Law Review 28.4 (1961): 629-662.
- Way, Jay. The Advantage of Depreciation Expense. Web 12 December 2017. http://smallbusiness.chron.com/advantages-depreciation-expense-22944.html
- Zeff, Stephen. “The IASB and FASB stumble over the annuity method of depreciation.” Accounting in Europe 11.1 (2014): 55-57.