Depreciation, in general conversation, is the decline in value of an asset due to wear and tear, becoming outdated, or actual destruction. Cars, homes, computers, factories, and all types of equipment undergo depreciation.
In accounting, depreciation is not an attempt to value an asset, but rather to allocate its cost over a period of time. The basic formula for depreciation is Cost minus salvage value, the result of which is divided by service life. While there are many different ways to calculate depreciation, the easiest to understand is straight line.
Suppose a company buys machinery for $50,000, expects it to last seven years and be sold for scrap for $1,000 at the end of seven years. Under straight line depreciation methods, the machine would be depreciated at $7,000 per year.
As a practical matter, most companies will have a depreciation policy which states how various broad categories of assets will be depreciated.
U.S. Tax Code
The U.S. Tax Code has undergone major, significant revisions of method and treatment of depreciation since it first began about 1919, and likely will continue to be revised in the future. Typically depreciable assets are classified as three year property, five year property, and ten year property; that is, assets with a three useful life (such as computers & furniture), five year useful (like automobiles) and ten year useful life (like buildings). This is commonly referred to as 10-5-3 Depreciation with schedules printed by the IRS showing how much of a capital investment could be deducted against income in a current year. In the early 1980s, Accelerated Depreciation was allowed for certain types of assets, later revised to Modified Accelerated Depreciation. The Section 179 Deduction now allows for "expensing", or writing off the total amount of a capital investment (within limits) in the same year the investment is made or property acquired.
Film actress Betty Grable, whose films grossed over $100 million, was the most famous pin-up girl of GIs during World War II and the highest paid Hollywood star. Her employer, Twentieth Century Fox studios, insured her legs as a capital asset with Lloyd's of London for $1,000,000, the premiums of which were a legitimate deductible business expense. Ronald Reagan, like Grable was also paying the top personal income tax rate of 92% during the New Deal. As Reagan aged and his face wrinkled, his ability to earn income diminished, but he was disallowed from depreciating the value of his primary capital asset - his face - against income. Reagan took up another career - politics - with a desire to reform an inherently flawed and unfair tax system.
- Election year rhetoric about "closing loopholes" and "tax cuts for the rich", when applied, usually relates to affecting depreciation schedules and classification.
- ACRS, or Accelerated Cost Recovery System.
- MACRS, or Modified Accelerated Cost Recovery System, a tax increase.