What is Asset Depreciation?
An asset is a tangible item which has a monetary value, such as a building, car, computer or bookcase. Most assets wear out and decrease in value, or depreciate, over time. If a business purchases an asset which has a life expectancy of more than one year, it cannot write off the full cost as an expense the year it is purchased. Instead, the cost is prorated over the expected life of an item, and that prorated amount is deducted as asset depreciation.
In accounting, an asset is depreciated differently for the profit and loss schedule than it is for income tax purposes. Asset depreciation for business purposes is based upon the actual time the company expects to use the item, while depreciation for tax purposes uses a set life expectancy based upon the class of property and determined by the governmental taxing authority. For example, a business may purchase a car it intends to only use for three years, so the asset depreciation will be spread over three years for the profit statements. The tax code, however, may require a vehicle to be depreciated over five years, so a different calculation is used when preparing the tax forms.
Asset depreciation can be calculated using a straight line method or some form of approved accelerated method. Straight line is relatively simple to calculate; the cost of the item is divided by the number of years it is expected to last and an equal amount of depreciation, or cost deduction, is taken every year. Using this method, an item which costs $5000 US Dollars (USD) and has an expected life of five years will be deducted, or depreciated, at a rate of $1000 USD per year. If the item is purchased or placed into service at any time other than the first of the year, then an adjustment must be made to the first and final years of the asset life.
Accelerated forms of depreciation are based upon set formulas or charts, and are frequently changed by legislative bodies. In times of economic prosperity, the amount of acceleration allowed may be reduced and the life expectancy of the class of assets may be extended. During economic downturns, governments may increase the amount of initial depreciation allowed and shorten class life expectancies to encourage businesses to increase spending on property assets.
In the US, the entire cost of the asset is allowed to be deducted, while the UK and Canada assign a salvage value to an item which cannot be deducted. If a car costs $10,000 USD and has a salvage value of $1,500 USD, then asset depreciation will be limited to $8,500 USD in those countries. Canada and the US both allow depreciation as a deduction on income tax. In the UK, depreciation is calculated solely for the purpose of determining the net worth of a business. The depreciation is added back into the net profit for tax purposes, and a percentage of the cost, called a capital allowance, is deducted on the return.
The calculation for asset depreciation of real estate is different, and is not based upon the cost of the entire property. The universal assumption is that the land upon which the buildings stand will last forever and therefore no depreciation is allowed. The structures, however, will wear out in time and need to be refurbished or replaced. To figure asset depreciation on real estate, most countries require that the value of the land be deducted form the total purchase price to calculate the portion assigned to the structures which can be depreciated.
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