Depreciation

In accounting, depreciation is a process whereby the value of an asset is allocated over a period of time. The concept comes from the fact that, over time, all assets decline due to normal wear and tear, obsolescence, or actual destruction. All assets of a business are depreciated, except for real estate (which appreciates over time in most cases) and some unusual items such as artwork or vintage automobiles.

Basics

In order to determine depreciation the company needs to determine four things about the asset:

• First, it needs to determine its historical cost. The cost is not just that of the asset, but may also include sales/use taxes, freight/shipping, and costs to install and test the asset for its intended use.
• Second, it needs to determine its useful life. This can be in terms of years or some unit of use or production.
• Third, it needs to determine its residual value (also called salvage value or scrap value, though it does not mean the asset is nothing but scrap or salvage at the end of its useful life). Although there are cases where an asset may have a negative residual value at the end of its useful life, for accounting purposes a residual value below zero is not used.
• Finally, it needs to determine a method of depreciation. Common methods of depreciation include straight-line (this is the most common and easiest to understand), units, declining balance, and sum-of-the-years-digits.

It should be noted that once an asset is fully depreciated, the company is still allowed to use the asset for business purposes. Also, a company will have a depreciation policy which states how various broad categories of assets will be depreciated, and may use different methods for different assets.

Example

A company buys machinery for $50,000, expects it to last five years, and at that time have a residual value of $5,000. It is also expected to produce 1,000,000 units during its useful life.

Straight-Line Depreciation

Under the straight-line method, the yearly depreciation is $9,000/year [($50,000 - $5,000) / 5 years]. This amount is recorded each year until, in Year 5, the residual value is reached.

Year	Value at Year Beginning	Depreciation	Value at Year End
1	$50,000	$9,000	$41,000
2	$41,000	$9,000	$32,000
3	$32,000	$9,000	$23,000
4	$23,000	$9,000	$14,000
5	$14,000	$9,000	$5,000

Units Depreciation

Under the units method, the yearly depreciation is calculated as a rate per unit. In the example above, the rate is $0.045/unit [($50,000 - $5,000) / 1,000,000 units].

This method requires additional recordkeeping to determine the number of units, in addition to normal records relating to depreciation. Also, if the production rate changes dramatically, adjustments may need to be made to how depreciation is calculated. For example, a machine may have been forecast to produce 1,000,000 units, but now due to economic circumstances will only produce 800,000 units before it becomes technologically obsolete.

The units can either be units of consumption (such as miles on an automobile) or units of production.

Declining Balance Depreciation

Under the declining balance method, the straight-line amount per year is expressed as a percentage of the total amount to be depreciated, then the percentage is increased by a certain amount. The most common is double-declining-balance (sometimes called "200% declining balance"), where the depreciation in the first year is double what it normally would be. However, "150% declining balance" is also used in some cases.

Under this method, the same percentage is applied each year to the historical cost without taking residual value into account. However, in the final year, the depreciation amount does take residual value into account, so the depreciation charge for that year is much smaller.

In the example above, the depreciation of $9,000/year is 20% of the total; using double-declining-balance, the percentage to be taken is 40% of the historical cost until, in Year 5, the residual value is reached.

Year	Value at Year Beginning	Depreciation	Value at Year End
1	$50,000	$20,000	$30,000
2	$30,000	$12,000	$18,000
3	$18,000	$7,200	$10,800
4	$10,800	$4,320	$6,480
5	$6,480	$1,480	$5,000

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.

Anecdotes

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.