The basic definition of depreciation is the decrease in value of property or assets. The decrease in value can be due to aging, wear and tear, or obsolescence. When a company buys a new machine, vehicle or building, its depreciation is calculated based on its useful life. There are many methods of calculating depreciation. The straight line method is the most popular technique, and is explained below.
In this method, the useful life of the asset, its scrap value and the original cost are considered. The difference between the original cost and the scrap value is divided by the useful life of the asset. In this method, it is assumed that the asset loses a fixed value every year throughout its useful life. The method to be used when calculating depreciation is normally chosen by the management of a company; normally the method that depreciates an asset fastest is preferred. Other methods include units of time, composite, group, units of production, reducing balance, sum of years’ digits and activity depreciation methods among others.
The tax code in many countries allows taxpayers to recover the cost of buying an asset through tax deductions. The depreciated cost of equipment is added to the expense column of the income statement as a tax deductible expense. However, the tax collection agency has strict guidelines as to the classification of different assets and their respective rates of depreciation. Assets are usually depreciated until the scrap value or salvage value is the same as the depreciated cost of the asset. It is important to note that land does not depreciate while intellectual properties depreciate.
In order to qualify the depreciated cost as a deductible expense, the taxpayer must own the asset. If the asset is leased, the taxpayer can deduct the depreciated cost of capital improvements made on the asset. The asset must also be used in an income generating activity or to conduct business. The asset must also have a useful life of more than 12 months.
Depreciation is very useful in business as it allows companies and individuals to recover the cost of procuring equipment, vehicles, machinery or buildings through tax deductions. The tax payable by a company or an individual can be reduced significantly by simply factoring-in the depreciated cost of assets.