Accounting Depreciation

The acquisition of fixed assets is an important activity for a business organization, whether the organization is starting up or acquiring new assets to remain competitive. The systematic allocation of the initial cost of an asset in parts over a time known as its depreciable life is what we mean by accounting depreciation. Because accounting depreciation is the standard of the business world, we sometimes refer to it more generally as asset depreciation.

The process of depreciating an asset requires that we make several preliminary determinations:

1. What can be depreciable? Depreciable property includes buildings, machinery, equipment, and vehicles. Inventories are not depreciable property because they are held primarily for sale to customers in the ordinary course of business. If an asset has no definite service life, the asset cannot be depreciated. For example, you can never depreciate land.

2. What cost base should be used in asset depreciation? The cost base of an asset represents the total cost that is claimed as an expense over an asset's life, that is, the sum of the annual depreciation expenses. The cost base generally includes the actual cost of the asset and all the other incidental expenses, such as freight, site preparation, and installation. This total cost, rather than the cost of the asset only, must be the depreciation base charged as an expense over the asset's life.

3. What is the assets value at the end of its useful life? The salvage value is an asset's value at the end of its life; it is the amount eventually recovered through sale, trade-in, or salvage. The eventual salvage value of an asset must be estimated when the depreciation schedule for the asset is established. If this estimate subsequently proves to be inaccurate, then an adjustment must be made.

4. What is the depreciable life of the asset? Historically, depreciation accounting included choosing a depreciable life that was based on the service life of an asset. Determining the service life of an asset, however, was often very difficult, and the uncertainty of these estimates often led to disputes between taxpayers and the IRS. To alleviate the problems, the IRS published guidelines on lives for categories of assets known as Asset Depreciation Ranges, or ADRs. These guidelines specified a range of lives for classes of assets based on historical data, and taxpayers were free to choose a depreciable life within the specified range for a given asset.

5. What method of depreciation do we choose? Companies generally calculate depreciation one way when figuring taxes and another way when reporting income (profit) to investors: (1) they use the straight-line method (or declining balance or sum-of-years' digits) for investors and (2) they use the fastest rate permitted by law (known as "modified accelerated cost recovery system [MACRS]") for tax purposes. Under the straight-line method, for an asset with a 5-year life which costs $10,000 and has a $1000 salvage value, the annual depreciation charge is ($10,000 -$1000)/5 = $1800. For tax purposes, Congress created several classes of assets, each with a more or less arbitrarily prescribed life called a recovery period or class life. The depreciable base is not adjusted for salvage value, which is the estimated market value of the asset at the end of its useful life. Table 17.4.1 describes what types of property fit into the different class life groups and the allowed depreciation percentages. Congress developed these recovery allowance percentages based on the declining balance method, with a switch to straight-line depreciation at some point in the asset's life. The MACRS recovery percentages as shown in Table 17.4.1 also employ the half-year convention — that is, they assume that all assets are put into service at midyear and, hence, generate a half-year's depreciation.

Project Management Made Easy

Project Management Made Easy

What you need to know about… Project Management Made Easy! Project management consists of more than just a large building project and can encompass small projects as well. No matter what the size of your project, you need to have some sort of project management. How you manage your project has everything to do with its outcome.

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