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What is Depreciation?
The value of various types of asset decreases over the years for various reasons. This is known as “depreciation”. The depreciation method is used for measuring that decrease. This accounting method allocates cost to a tangible asset over its useful lifespan. It is used for tax and accounting purposes.
A Little More on What is Depreciation
Depreciation is a measured conversion of the cost of an asset into an operational expense. Depreciation affects the net income reported and balance sheet of a company.
Business tools and equipment are generally the assets that depreciate over the years. The cost of the purchased tangible assets can be deducted as business expenditures (expense), which in turn reduces the taxable income. In order to secure the tax deduction, a company must follow the IRS rules while depreciating their assets. The IRS has fixed rules on how and when a company can claim such deductions.
Depreciation does not involve any real cash flow. The value of an asset decreases due to a number of reasons including wear and tear or obsolescence.
Different countries have different laws and regulations for calculating depreciation. The calculation method of depreciation and the time period for depreciation may vary from one asset to another within the same company. The methods employed under the US tax code include:
- Fixed percentage – The company can deduct a fixed percentage of the value of the asset each year.
- Straight line – This means that a fixed amount is allowed to be deducted each year.
- Declining balance – This allows for deduction of a percentage of the specific method that changes each year.
Usually, the depreciation process begins when a company starts using an asset. For example, a business installs a machine with $70, 000 in the factory. They may be able to write off the total expense in the first year itself (via “accelerated depreciation”) or they may write off the value of the machine over the 7 years of the machine’s useful lifespan. The seven year period is a standard period for many types of equipment. In this case, the depreciation expense would be 1,000 per year for 7 years.
Depreciation is also relevant for book accounting (rather than tax accounting). The loss of market value is calculated for the purpose of demonstrating the value of company assets. Technology changes, market conditions, and economic turmoil can affect the value of such assets. In some instances, even assets like currency and real estate can depreciate over time. The price of the real estates dropped dramatically during the real estate crisis in 2008 after the housing bubble burst. The homeowners in Las Vegas witnessed a depreciation of as much as 50% during that crisis. (Note: Depreciation of real estate is generally not allowed for tax purposes.)
References for Depreciation
Academic Research for Depreciation
- · The acquisition, transfer, and depreciation of knowledge in service organizations: Productivity in franchises, Darr, E. D., Argote, L., & Epple, D. (1995). Management science, 41(11), 1750-1762. This study helps to demonstrate how businesses learn, and what that learning means in terms of profit and productivity. By studying 36 restaurants in a chain over an 18-month period, the authors find that learning can significantly lower production costs. They also find that learning transfers between stores owned by the same franchisee, but transfers poorly between locations owned by different franchisees.
- · Tax deductibility of economic depreciation to insure invariant valuations, Samuelson, P. A. (1964). Journal of political Economy, 72(6), 604-606. This study examines the way that marginal tax rates affect the value of economic depreciation. By using mathematical models the authors derive a formula to more accurately shape the definition of income.
- · Market response to changes in depreciation accounting, Comiskey, E. E. (1971). The accounting review, 46(2), 279-285. This study attempts to find the actual market effect that comes from changes in the way that accounting standards view depreciation. By analyzing data from 11 steel companies in the late 1960s, the author the impact of these changes is presented. Reasons for these changes are discussed, and predictions regarding future behavior of both the markets and industry are presented.
- · Resource Accounting and Budgeting: From Cash to Accruals in 25 Years, Perrin, J. (1998). Public Money and Management, 18(2), 7-10. This piece presents a personal history in public sector accounting. The author looks back over 25 years in the industry. He gives particular emphasis to the period when accruals accounting replaced cash accounting. He offers personal analysis on those innovations and the impact these changes caused.
- · Lee v. Neuchatel Asphalte Company (1889) and depreciation accounting: Two empirical studies, Morris, R. D. (1986). Accounting and Business Research, 17(65), 71-81. This article examines the impact of the decision from Lee v. Nechatel Asphalte Company. Decided by the English courts in 1889, this decision allowed Neuchatel Asphalte to use depreciation accounting when determining its dividend payments. This piece looks at how the decision changed industry and the financial markets when depreciation was allowed in as part of standard accounting practices.
- · Economic depreciation, accounting depreciation, and their relation to current cost accounting, Bar-Yosef, S., & Lustgarten, S. (1994). Journal of Accounting, Auditing & Finance, 9(1), 41-60. This research presents an analysis that compares the different ways of determining asset value in U.S. industries. A simulation is used to find the differences between economic value, accounting value, and cash value of assets. This simulation also tracks these changes over time. External forces like inflation and accounting practices are also considered.
- · A case for depreciation accounting in UK Health Authorities, Lapsley, I. (1981). Accounting and Business Research, 12(45), 21-29. This paper discusses the need for addressing the accounting practices of Health Authorities in the UK. Because these entities are not profit-oriented, they’re accounting practices are often overlooked. The author takes a look at the implications of depreciating assets in the UK’s hospitals and health-oriented operations.
- · Depreciation policy and the behavior of corporate profits, Barefield, R. M., & Comiskey, E. E. (1971). Journal of Accounting Research, 351-358. This paper examines the implications that different accounting practices can have on the stock price of publicly held companies. The fact that wildly changing earnings can have a negative fact on share price is commonly held, and keeping this in mind, the author examines how depreciation accounting can affect a firm’s asset value.
- · The application of depreciation accounting to the National Health Service, Mellett, H. (1992). Accounting, Business & Financial History, 2(2), 161-180. This paper examines how deprecation has been employed in the National Health Service’s accounting practices. From 1948 to 1991, depreciation has been alternately used and rejected by government accountants. The author looks at the reasoning behind these changes, and the impact that the changes have had on NHS operations and financial statements.
- · A brief history of property and depreciation accounting in municipal accounting, Potts, J. H. (1982). Accounting Historians Journal, 9(1), 25-37. This paper examines the historical attitudes and practices that surrounded the use of depreciation as a part of generally accepted accounting principles. Arguments from the time on both sides of the debate are included and analyzed.
- · Depreciation accounting methods for public utilities, Nash, L. R. (1930). Accounting Review, 125-141. This article addressing how depreciation is treated when reconciling the books of a public utility. Because public utilities are often state-regulated monopolies, their attitude toward profit and expense sometimes differ from firms doing business in the open market. This piece analyzes the history, theory, and practices that surround the use of depreciation in accounting systems employed by public utilities.
- · The role of resource accounting in the UK government’s quest for ‘better accounting‘, Mellett, H. (1997). Accounting and Business Research, 27(2), 157-168. This paper examines an effort by the UK government to employ a system of resource accounting that would include depreciation charges in the governmental balance sheet. The author engages in a thorough a careful analysis of the proposed changes. They conclude that the change in accounting practices doesn’t appear to offer any of the benefits that are listed in the proposal’s white paper.