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Main Dictionary D

Depreciation

Depreciation is considered the process of deducting the total cost of any expensive purchase made for a business, and this write-off can occur in parts over several tax periods, contributing to the improvement of the financial situation of the enterprise. Since most of tangible assets decrease in value during their use, they can be depreciated by the company. 

More about a Depreciation

The term depreciation covers only the property and physical assets of the enterprise, while amortization relates to the intangible assets, such as a patent or other intellectual property. When a business acquires an asset, a company car, a computer, or something else that may lose value over time, it is allowed to write off the amount of value that the asset loses each year. This process, known as depreciation, allows a business to pay taxes based on how much an asset is worth over time rather than always being calculated as if it were new. 

A depreciation helps to figure out how much value assets lost over the time because of wear and tear and to estimate this decline. A depreciation links together the costs of using a tangible asset with the benefits that can be received during its usage. With this information, the company can compare its income with costs and to evaluate the costs of assets that are actively used to generate revenue. 

For instance, If some machine is acquired by a company at a price of $10000, and the expected usage of it is 5 years, the business can depreciate the asset under depreciation expense as $2000 every year for a period of 5 years. In this case, a depreciation helps to have revenue from these assets right now, paying for them over a certain time period. A threshold amount for beginning to depreciate the fixed assets of the company is set individually, and different companies can have different thresholds. 

Accounting and taxes of a Depreciation

Many companies choose to expense a portion of the cost, because it allows them to increase net income. Assets that an entity plans to use over a lengthy period of time may be depreciated for tax and accounting purposes. For tax credits, accounting depreciation schedules can be created, as asset depreciation is deductible as a business expense (Internal Revenue Service rules). In addition, depreciation decrease the asset carrying value, but it is not affect a real cash outflow.

The main journal entry for depreciation is to debit the Depreciation Expense account (it is reflected in the income statement) and credit the Accumulated Depreciation account (it is reflected in the balance sheet as a contra account that decreases the digit of fixed assets). Gradually, as depreciation is added, the accumulated depreciation balance will increase, until the amount comes to the original cost of the property.

Accumulated depreciation

An accumulated depreciation is the total cost of an asset written off as an expense. It is the amount of the total cost that has been spent since its purchase.

Accumulated depreciation is a contra asset account. This type of account on the balance sheet is called so because it works against the asset. As an example, an asset may have been worth $5,000 at the time it was purchased, but depreciated to $2,000 some time later. The $2,000 will be included in the balance sheet against the $5,000.

The amount balancing the current value of property and equipment, accrued from the date of their acquisition and representing depreciation. 

The term of depreciation expenses is more popular than accumulated depreciation, as it is widely used for deductions and helps in reducing the company's tax liability. However, both terms are reflected in annual and quarterly reports. The amount of accumulated depreciation affects the valuation of the business, since it constantly changes on the balance sheet. It is also needed to predict the life of an object.

Depreciation methods

Straight-line method. It means the same depreciation expense every year during the useful life of the asset, until the asset is depreciated in full to its salvage value. For example, the asset will be used by the company for 3 years. This asset has been purchased at the price of $30,000, so the depreciation expense will be $10,000 each and every year. 

Declining balance method. The asset is depreciated by the same rate for each year of its useful life. As an example, 10% is a rate of a depreciation, using the numbers from example above, the expense of a depreciation is $3,000 in the first year, $2,700 the second year, $1,890 the third year and so on.

Double-declining balance (DDB) technique. This accelerated method is often used for equipment which is more productive in its first years and lose value quickly. That means that the company get the biggest tax write-offs in the years right after they have bought the asset, and they depreciate less each year after that. 

In the first year of the asset depreciation, the company take double the amount it would take under the straight-line method. In subsequent years, the company will apply that rate of depreciation to the asset’s remaining book value rather than its original cost. Book value is the asset’s cost minus the amount the company have already written off. A salvage value is not taken into account when using the double declining balance method.

For example, an asset with a useful life of five years would have a reciprocal value of 1/5, or 20%. Double the rate, or 40%, is applied to the asset's current book value for depreciation. Although the rate remains constant, the dollar value will decrease over time because the rate is multiplied by a smaller depreciable base for each period.

Sum-of-the-years' digits (SYD). Since the productivity of an asset is declining every year, the sum-of-the-years’ digits method accrues higher depreciation expenses in the early years of the asset's useful life and lower expenses in later years.

If an asset have a useful life equals 3 years, it would have a base of the sum of the digits one through five, or 1 + 2 + 3 = 6. In the first depreciation year, 3/6 of the depreciable base would be depreciated. In the second year, 2/6 of the depreciable base would be depreciated and 1/6 of the base in the third year.

Units of production. Some assets can be depreciated not by age, but by their usage. This method shows how much an asset will produce during its life. Depreciation expense is then calculated per year based on the number of units produced. This method also calculates depreciation expenses based on the depreciable amount.

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