📉 Depreciation in Accounting and Tax

What depreciation means: a fall in an asset's value and the allocation of its cost over time
The accounting concept: depreciable assets, the four criteria, depreciable basis
Related ideas: impairment, depletion and amortization, effect on cash, accumulated depreciation
Methods: straight-line, diminishing balance, activity-based, sum-of-years-digits, units-of-production, group and composite
Tax depreciation: capital allowances, tax lives, additional first-year deductions, real property, averaging conventions, fixed rates

💡 What Depreciation Means

In accountancy, depreciation refers to two aspects of the same concept:

An actual reduction in the fair value of an asset, such as the decrease in value of factory equipment each year as it is used and wears.
The allocation in accounting statements of the original cost of the asset to the periods in which the asset is used (depreciation with the matching principle).

Depreciation is therefore both the decrease in the value of assets and the method used to reallocate, or "write down", the cost of a tangible asset (such as equipment) over its useful life span.

Businesses depreciate long-term assets for both accounting and tax purposes.
The decrease in value affects the balance sheet of a business or entity.
The method of depreciating the asset affects net income, and thus the income statement that the business reports.
Generally, the cost is allocated as depreciation expense among the periods in which the asset is expected to be used.

📘 The Accounting Concept

Why costs are allocated

To determine net income (profits) from an activity, the receipts from the activity must be reduced by appropriate costs.
One such cost is the cost of assets used but not immediately consumed in the activity.
The cost allocated in a given period equals the reduction in the value placed on the asset.
That value is initially equal to the amount paid for the asset. Afterwards it may or may not be related to the amount expected to be received upon its disposal.

Depreciation is any method of allocating such net cost to those periods in which the organization is expected to benefit from the use of the asset.

Depreciation is the process of deducting the cost of an asset over its useful life.
Assets are sorted into different classes, and each class has its own useful life. The asset is referred to as a depreciable asset.
Depreciation is technically a method of allocation, not valuation, even though it determines the value placed on the asset in the balance sheet.

Deferring costs

Any business or income-producing activity using tangible assets may incur costs related to those assets.
If an asset is expected to produce a benefit in future periods, some of these costs must be deferred rather than treated as a current expense.
The business then records depreciation expense in its financial reporting as the current period's allocation of such costs.
This is usually done in a rational and systematic manner.

The four criteria

Generally, depreciation involves four criteria:

Cost of the asset
Expected salvage value, also known as the residual value of the asset
Estimated useful life of the asset
A method of apportioning the cost over such life

Depreciable basis

Cost generally is the amount paid for the asset, including all costs related to acquiring and bringing the asset into use.
In some countries or for some purposes, salvage value may be ignored.
The rules of some countries specify lives and methods to be used for particular types of assets.
In most countries, however, the life is based on business experience, and the method may be chosen from one of several acceptable methods.

⚠️ Impairment

Accounting rules also require that an impairment charge or expense be recognized if the value of assets declines unexpectedly.
Such charges are usually nonrecurring and may relate to any type of asset.
Many companies consider write-offs of some of their long-lived assets because some property, plant, and equipment have suffered partial obsolescence.
Accountants reduce the asset's carrying amount by its fair value.
Example: if a company continues to incur losses because prices of a particular product or service are higher than the operating costs, the company may consider writing off the particular asset. These write-offs are referred to as impairments.

Events that might lead to impairment

A large decrease in the fair value of an asset
A change in the manner in which the asset is used
Accumulation of costs that were not originally expected in acquiring or constructing an asset
A projection of incurring losses associated with the particular asset
Events or changes in circumstances indicating that the company may not be able to recover the carrying amount of the asset

The recoverability test

When such circumstances arise, companies use the recoverability test to determine whether impairment has occurred. The steps are:

Estimate the future cash flow of the asset (from the use of the asset to its disposition).
If the sum of the expected cash flow is less than the carrying amount of the asset, the asset is considered impaired.

🛢️ Depletion and Amortization

Depletion and amortization are similar concepts to depreciation, applied to different kinds of assets.

Term	Applies to
Depreciation	Tangible assets such as equipment
Depletion	Natural resources (including oil)
Amortization	Intangible assets

💵 Effect on Cash

Depreciation expense does not require a current outlay of cash.
Depreciation is an expense on the P&L account. Provided the enterprise is operating in a manner that covers its expenses (for example, operating at a profit), depreciation is not a direct source of cash.
It is a non-cash expense that is "added back" on the statement of cash flows to reconcile net income with cash from operations.

🧾 Accumulated Depreciation

Depreciation expense is recorded on the income statement. Its impact is generally recorded in a separate account and disclosed on the balance sheet as accumulated under fixed assets, according to most accounting principles.
Accumulated depreciation is a contra account, because it separately shows a negative amount that is directly associated with the asset on the balance sheet.
Depreciation expense is usually charged against the relevant asset directly. Otherwise, it is charged against accumulated depreciation.
The values of fixed assets stated on the balance sheet will decline, even if the business has not invested in or disposed of any assets. Theoretically, the amounts will roughly approximate fair value.
Showing accumulated depreciation separately has the effect of preserving the historical cost of assets on the balance sheet.
If there have been no investments or dispositions in fixed assets for the year, the values of the assets will be the same on the balance sheet for the current and prior year.

🧮 Methods for Depreciation

There are several methods for calculating depreciation, generally based on either the passage of time or the level of activity (or use) of the asset.

Method	Basis	Pattern
Straight-line	Time	Same amount each year
Diminishing (declining) balance	Time	Accelerated, larger in early years
Sum-of-years-digits	Time	Accelerated, schedule of fractions
Activity-based (e.g. miles driven)	Use	Varies with level of activity
Units-of-production	Use	Larger in years of heavy use
Group and composite	Pools of assets	Applied to a collection of assets

Straight-line depreciation

Straight-line depreciation is the simplest and most often used method.

It is calculated by dividing the difference between the asset's cost and its expected salvage value by the number of years of its expected useful life.
The salvage value may be zero, or even negative due to costs required to retire it. However, for depreciation purposes salvage value is not generally calculated at below zero.
The company charges the same amount to depreciation each year, until the value shown for the asset has reduced from the original cost to zero (or to its salvage value).

\text{annual depreciation expense} = \frac{\text{cost of fixed asset} - \text{residual value}}{\text{useful life of asset (years)}}

Example: a vehicle that depreciates over 5 years is purchased at a cost of $17,000 and will have a salvage value of $2,000. The vehicle depreciates at $3,000 per year, since $(17 - 2)/5 = 3$ .

Book value at the beginning of the first year of depreciation is the original cost of the asset.
Book value equals original cost minus accumulated depreciation: $\text{book value} = \text{original cost} - \text{accumulated depreciation}$ .
Book value at the end of a year becomes book value at the beginning of the next year.
The asset is depreciated until the book value equals scrap value.

Selling the asset

If the sales price exceeds the depreciated value (net book value), the excess is considered a gain and is subject to depreciation recapture. This gain above the depreciated value is recognized as ordinary income by the tax office.
If the sales price is less than the book value, the resulting capital loss is tax-deductible.
If the sale price is more than the original book value, the gain above the original book value is recognized as a capital gain.

Timing differences

If a company chooses to depreciate an asset at a different rate from that used by the tax office, this generates a timing difference in the income statement. It arises from the difference (at a point in time) between the taxation department's and the company's view of the profit.

Diminishing balance method

The double-declining-balance method, or reducing balance method, calculates an asset's accelerated rate of depreciation against its non-depreciated balance during the earlier years of the asset's useful life.

When using it, the salvage value is not considered in determining the annual depreciation.
However, the book value of the asset being depreciated is never brought below its salvage value, regardless of the method used.
Depreciation ceases when either the salvage value or the end of the asset's useful life is reached.
Since double-declining-balance depreciation does not always depreciate an asset fully by the end of its life, some methods also compute a straight-line depreciation each year and apply the greater of the two. This converts from declining-balance depreciation to straight-line depreciation at a midpoint in the asset's life.
The method is also a better representation of how vehicles depreciate and can more accurately match cost with benefit from asset use.

With the declining balance method, one can find the depreciation rate that allows exactly for full depreciation by the end of the period:

\text{depreciation rate} = 1 - \sqrt[N]{\frac{\text{residual value}}{\text{cost of fixed asset}}}

where $N$ is the estimated life of the asset (for example, in years).

Activity-based depreciation

These methods are not based on time, but on a level of activity, such as miles driven for a vehicle or a cycle count for a machine.

When the asset is acquired, its life is estimated in terms of this level of activity.
Example: the vehicle above is estimated to go 50,000 miles in its lifetime. The per-mile rate is ($17,000 − $2,000) / 50,000 = $0.30 per mile.
Each year, the depreciation expense is the number of miles driven multiplied by the per-mile depreciation rate.

Sum-of-years-digits method

Sum-of-years-digits (SYD) is a depreciation method that results in a more accelerated write-off than the straight-line method, and typically also more accelerated than the declining balance method.

Under this method, the annual depreciation is determined by multiplying the depreciable cost by a schedule of fractions.
It is one of the accelerated depreciation techniques, which are based on the assumption that assets are generally more productive when they are new and that their productivity decreases as they become old.

\text{SYD depreciation} = \text{depreciable base} \times \frac{\text{remaining useful life}}{\text{sum of the years' digits}}

\text{depreciable base} = \text{cost} - \text{salvage value}

Example: an asset has an original cost of $1,000, a useful life of 5 years and a salvage value of $100.

The years' digits for a 5-year life are 5, 4, 3, 2 and 1.
The sum of the digits is $5+4+3+2+1 = 15$ .
The sum can also be found with the formula $(n^2+n)/2$ , where $n$ is the useful life in years: $(5^2+5)/2 = 15$ .

Year	Depreciation rate
1st	5/15
2nd	4/15
3rd	3/15
4th	2/15
5th	1/15

Units-of-production method

This method calculates greater deductions for depreciation in years when the asset is heavily used.

\text{annual depreciation expense} = \frac{\text{cost of fixed asset} - \text{residual value}}{\text{estimated total production}} \times \text{actual production}

Example: an asset has an original cost of $70,000, a salvage value of $10,000, and is expected to produce 6,000 units.

Depreciation per unit = ($70,000 − $10,000) / 6,000 = $10.
Multiplying $10 by actual production gives the depreciation cost of the current year.
Depreciation stops when book value equals the scrap value of the asset.
In the end, the sum of accumulated depreciation and scrap value equals the original cost.

Group depreciation method

Used for depreciating multiple-asset accounts using a similar depreciation method.
The assets must be similar in nature and have approximately the same useful lives.

Composite depreciation method

The composite method is applied to a collection of assets that are not similar and have different service lives. For example, computers and printers are not similar, but both are part of office equipment. Depreciation on all assets is determined using the straight-line method.

Quantity	Definition	Example
Composite life	Total depreciable cost divided by total depreciation per year	$5,900 / $1,300 = 4.5 years
Composite depreciation rate	Depreciation per year divided by total historical cost	$1,300 / $6,500 = 0.20 = 20%
Depreciation expense	Composite rate times the balance in the asset account (historical cost)	0.20 x $6,500 = $1,300

To record depreciation, debit depreciation expense and credit accumulated depreciation.
When an asset is sold, debit cash for the amount received and credit the asset account for its original cost. Debit the difference between the two to accumulated depreciation.
Under the composite method, no gain or loss is recognized on the sale of an asset. Theoretically, this makes sense because the gains and losses from assets sold before and after the composite life will average themselves out.
Multiplying the composite rate by the same total historical cost simply gives back the total depreciation per year.

🏛️ Tax Depreciation

Most income tax systems allow a tax deduction for recovery of the cost of assets used in a business or for the production of income. Such deductions are allowed for individuals and companies.
Where assets are consumed currently, the cost may be deducted currently as an expense or treated as part of cost of goods sold.
The cost of assets not currently consumed generally must be deferred and recovered over time, such as through depreciation.
Some systems permit the full deduction of the cost, at least in part, in the year the assets are acquired. Other systems allow depreciation expense over some life using some depreciation method or percentage.
Rules vary highly by country, and may vary within a country based on the type of asset or type of taxpayer.
Many systems that specify depreciation lives and methods for financial reporting require the same lives and methods to be used for tax purposes.
Most tax systems provide different rules for real property (buildings, etc.) and personal property (equipment, etc.).

Capital allowances

A common system allows a fixed percentage of the cost of depreciable assets to be deducted each year. This is often called a capital allowance, as in the United Kingdom.
Deductions are permitted to individuals and businesses based on assets placed in service during or before the assessment year.
Canada's Capital Cost Allowance uses fixed percentages of assets within a class or type of asset.
The percentages are specified by the tax law or regulations of the country, by type of asset, and multiplied by the tax basis of assets in service to determine the deduction.
Calculations may be based on the total set of assets, on sets or pools by year (vintage pools), or on pools by classes of assets.

Tax lives and methods

Some systems specify lives based on classes of property defined by the tax authority. The Canada Revenue Agency specifies numerous classes based on the type of property and how it is used.
Under the United States system, the Internal Revenue Service publishes a detailed guide with a table of asset lives and the applicable conventions.
The table also specifies lives for certain commonly used assets (for example office furniture, computers, automobiles), which override the business use lives.
U.S. tax depreciation is computed under the double-declining balance method switching to straight line, or the straight-line method, at the option of the taxpayer.
IRS tables specify percentages to apply to the basis of an asset for each year in which it is in service.
Depreciation first becomes deductible when an asset is placed in service.

Additional depreciation

Many systems allow an additional deduction for a portion of the cost of depreciable assets acquired in the current tax year.

Jurisdiction	Additional deduction
United Kingdom	First-year capital allowance of £50,000
United States (1)	Full cost of depreciable tangible personal property, up to $500,000 through 2013; fully phased out for businesses acquiring over $2,000,000 of such property in the year
United States (2)	Additional first-year depreciation of 50% of the cost of most other depreciable tangible personal property

Some other systems have similar first-year or accelerated allowances.

Real property

Many tax systems prescribe longer depreciable lives for buildings and land improvements. Such lives may vary by type of use.
Many such systems, including the United States, permit depreciation for real property using only the straight-line method, or a small fixed percentage of the cost.
Generally, no depreciation tax deduction is allowed for bare land.

United States lives, all using the straight-line method:

Property	Life
Residential rental buildings	27.5 or 40 years
Other buildings	39 or 40 years
Land improvements	15 or 20 years

Averaging conventions

Depreciation calculations require a lot of record-keeping if done for each asset, especially if assets are added to after acquisition or partially disposed of.
Many tax systems permit all assets of a similar type acquired in the same year to be combined in a pool, with depreciation computed for the pool as a single calculation.
These calculations must make assumptions about the date of acquisition.
The U.S. system allows a half-year convention for personal property or a mid-month convention for real property. Under such a convention, all property of a particular type is considered to have been acquired at the midpoint of the acquisition period.
One half of a full period's depreciation is allowed in the acquisition period (and also in the final depreciation period if the life of the assets is a whole number of years).
U.S. rules require a mid-quarter convention for property if more than 40% of the acquisitions for the year are in the final quarter.

Fixed rate of depreciation

In many countries, for tax purposes, a fixed rate is deemed for a class of asset. At that rate, depreciation is charged and claimed as an expense in the profit and loss account for the purpose of the tax expense allowance.

Depreciation: Accounting Study Notes