Depreciation: An Overview

Depreciation is an allowance for the decline in an asset's value. It has two aspects, an accounting aspect and a practical aspect. Both aspects have tax and financial implications.

In accounting terms, depreciation is the process of allocating the cost of tangible property against income over a period of time, rather than deducting the cost as a cash expense in the year of acquisition. Generally, at the end of an asset's life, the sum of the amounts set aside for depreciation each accounting period will equal original cost less salvage value (the value of an asset at the end of its life). The method used to calculate an asset's depreciation is important because depreciation affects net profit. Higher depreciation deductions reduce net profit while lower depreciation deductions increase net profit.

In practical terms, depreciation suggests a gradual decline in an asset's market value because of use and wear and tear. Federal and state tax laws recognize that businesses need to account for this aspect of depreciation. As a result, IRS and state tax authorities allow businesses to write off or expense a certain amount each year for the actual use of an asset. This amount is treated as an expense even though the company may not have purchased the asset in the current period.

Good accounting and financial management practices require that a company take both the cost expiration and the declining market value of an asset into account. The cost expiration of a company's assets must be recognized if the cost of doing business is to be realistic. Also, the decline in the market value of those assets must be considered if the company's net worth is to be realistic.

The application is concerned solely with fixed assets, which the IRS defines as property or equipment with an estimated life in excess of 1 year. Note that the system does support assets with a life as short as 6 months for the following depreciation methods:

MF150% and MA150% (MACRS Formula)

AD and AA (MACRS Alternative Depreciation System).

Note that the system does not support assets with a life as short as 1 month for the following depreciation methods:

To be depreciated, a fixed asset must:

be used in business or held for the production of income,

have an estimated life greater than 1 year,

be subject to wear, decay, or expiration, and

be fully installed and ready for use.