What is Depreciation?
As a financial term, “depreciation” refers to the following separate, but related concepts:
o Depreciation may refer to the decline in the value of assets
o Depreciation may also refer to the allocation of the cost of assets to periods where the assets are used
• The first definition of depreciation affects the values of goods, assets, businesses and entities, while the latter predominantly affects net income.
Different entities will define depreciation in an assortment of ways; however, in a general sense, the term refers to the diminishing value attached to a good, asset or business organization as a result of the underlying object’s wear and tear, obsolescence or deterioration. For example, if a consumer purchases a television, with the most updated technology, that particular television will invariably undergo depreciation within the next five years, as newer and better televisions hit the market.
Depreciation in Accounting:
When determining the profits (net income) from a specific activity, the receipts from the activity must be reduced by the appropriate costs. One such cost is the expense of the underlying assets used, but not necessarily consumed, in the activity. The cost of an asset is the difference between the amount paid for the asset and the amount expected to be received upon its forfeiture, sale or disposition.
Depreciation refers to any method of allocating such net costs to those periods expected to benefit from the use of the asset. As a result, depreciation is a method of allocation and not valuation in accounting.
Any business using tangible assets may incur costs related to the aforementioned asset groups. When the assets produce a benefit in future periods, the costs must be deferred rather than treated as current expenditures. The business will then record depreciation expenses as an allocation of such costs for financial reporting purposes. When evaluating deprecation as an accounting concept the following criteria must be analyzed: the cost of the asset, the estimated useful life of the asset, a method of apportioning the cost over such life and the expected savage value or residual value of the asset.
How does the IRS define Depreciation?
The Internal Revenue Service defines depreciation as an income tax deduction that allows a taxpayer to recover the cost of certain property. Depreciation, in regards to taxation, refers to the annual allowance for the wear and tear, deterioration or obsolescence of the property.
The majority of tangible property (with the exception of land), such as buildings, vehicles, machinery, furniture and equipment are depreciable. In order for a taxpayer to be allowed a depreciation deduction for a property, the investment must meet all the following requirements:
o The taxpayer must own the property
o The taxpayer must use the property in business or in an income-producing activity.
o The property must possess a determinable useful life of more than one year.