Depreciation affects the "accounting procedure" for determining profits and losses and the income tax of a company. In other words, for tax purposes the expenditure for an asset such as a pump or motor cannot be fully expensed in its first year. The original investment must be charged off for tax purposes over the useful life of the asset. A company usually wishes to expense an item as quickly as possible.
The Internal Revenue Service allows several methods for determining the annual depreciation rate. Tax considerations based on the tax reform act of 1986 are described in Chapter 8.
Straight-Line Depreciation. The simplest method is referred to as a straight-line depreciation and is defined as:
L is the value of equipment at the end of its usefullife, commonly referred to as salvage value is the life of the equipment, which is determined by Internal Revenue Service guidelines P is the initial expenditure.
Sum-of-Years Digits. Another method is referred to as the sum-of-years digits. In this method the depreciation rate is determined by finding the sum of digits using the following formula, where n is the life of equipment.
Each year's depreciation rate is determined as follows.
First year Second year
Declining-Balance Depreciation. The declining-balance method allows for larger depreciation charges in the early years which is sometimes referred to as fast write-off.
The rate is calculated by taking a constant percentage of the declining undepreciated balance. The most common method used to calculate the declining balance is to predetermine the depreciation rate. Under certain circumstances a rate equal to 200 percent of the straight-line depreciation rate may be used. Under other circumstances the rate is limited to or ^ times as great as straight-line depreciation. In this method the salvage value or undepreciated book value is established once the depreciation rate is preestablished. To calculate the undepreciated book value, Equation 2-22 used.
D is the annual depreciation rate L is the salvage value P is the first cost.
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