Depreciation can be easily defined as the decrease in value of any asset, through use, wear and tear, and age.
The first thing to be determining when depreciating an asset is its initial cost, which is the cost to purchase the asset plus any costs incurred to get the asset ready to use. Examples of these extra costs are: sales taxes, freight and installation costs.
After determining the initial cost and by the time the asset is placed in service, the expected useful life should be determined. Â According to the Internal Revenue Service guidelines, most machinery and equipment have a useful life of seven years, while automobiles and light duty trucks have a useful life of five years. Even though these are mandatory for federal income tax purposes, companies may decide using different expected useful life for financial reporting purposes.
The last information to be determined before depreciating an asset is its residual value at the end of the useful life. The residual value is the estimated value of the asset at the end of its useful life. The depreciable cost of the asset will be the difference between its initial cost and its residual value. As a consequence, if an asset is expected to have no residual value, the entire initial cost must be depreciated.
Among the several methods of depreciation, the most common are: straight line method, the 200 percent declining-balance method, the Service Hours method, the Sum of the Years Digits method and the Modified Accelerated Cost Recovery System (MACRS).
The straight-line method assumes the asset will lose an equal amount of value each year. It is consider the simplest and most commonly used method of depreciation. The depreciation is calculated dividing the depreciable value (initial costs minus residual value) by the estimated useful life of the asset.
The 200 percent declining-balance method permits the use of twice the rate of annual depreciation as the straight-line method. In this method, the residual value is not considered when determining the depreciation rate. Also, the asset cannot be depreciate bellow its estimated residual value.
The Service Hours method uses the total hours the asset has been used in each year in comparison with the estimated total hours of useful life. Due the necessity of keeping up with the hours of work of each asset, this method has an increased difficulty level and therefore less practical use.
The Sum of the Year's Digits method was created to allow the depreciation rate to diminish as it get closer to the end of the asset useful life. The rationale is that as older an asset is, the less productive it is. The depreciation rate is calculated by adding up the asset estimated useful life number of years and dividing by the number of years of the remaining useful life.
The Modified Accelerated Cost Recovery System (MACRS) is the current method of accelerated asset depreciation required by the United States income tax code. In this method, assets are divided into classes by the number of years over which an asset's cost will be recovered. Each MACRS class has a predetermined schedule, which determines the percentage of the asset's cost which is depreciated each year.
Some companies keep one set of depreciation records for financial accounting and another for preparing their taxes. This is the value of assets and is reflected in a company's profits, so it is important to ascertain the truest value however, because companies are also taxed on their assets, a lower value would result in lower taxable income.
When comparing the depreciation methods it is important to note that several benefits arise from using the accelerated method as opposed to the straight-line. One benefit relates to offsetting future expenses in the upkeep of the asset. Often this approach is more logical when the annual benefit from the asset’s use decreases with age and the asset’s cost of repair and maintenance increases. By offsetting the increased repair and maintenance costs, the accelerated method equalizes the combined charges of both repairs and depreciation.
By accelerating the depreciation to offset the repairs and maintenance, in the end the overall costs are shown on a straight-line. If the straight-line were used, then the depreciation would be constant, but the repairs and maintenance costs would increase causing the total expenses to increase.
Another benefit would be if the asset was anticipated to provide significant benefit early on in the useful life, and future benefit less definite or if the asset has the potential to become obsolete or inadequate at a premature date. As an example, continual technological improvements often make computers become obsolete or at least inadequate for their purpose. As a result, by using the accelerated approach, the depreciation expense can be taken early when the computers are still used and providing benefit for the company.
Companies also use the accelerated method to make an allowance for inflation. The aggregate depreciation increases during periods when the amount of property, plant, and equipment is growing or if conservative estimates of useful life or salvage values are used. In simpler terms, by expensing more of the cost of the asset at the beginning, then in the future when inflation causes expenses to be higher, the amount of expense will be lower.
Last, and maybe the most relevant advantage of the accelerated method, are the tax benefits. Increasing the expenses at the present time allow companies to defer part of taxes to future years.
Leandro Maya, MBA Student at West Chester University
Article Source:http://www.articlesbase.com/accounting-articles/depreciation-1321541.htmlOrignal From: Depreciation
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