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Depreciation is an estimate of the decrease in the value of an asset, caused by wear and tear or by obsolescence. The use of depreciation affects a company's (or an individual's) financial statements, and, in some countries, their taxes.
In economics, depreciation is the decrease in value of the capital stock (physical depreciation). If capital stock is <math>C_0<math> at the beginning of a period, investment is <math>I<math> and depreciation <math>D<math>, the capital stock at the end of the period, <math>C_1<math>, is <math>C_0 + I - D<math>.
Accounting
A company needs to report depreciation accurately in its financial statements in order to achieve two main objectives. Firstly, to match its expenses with the income generated by means of those expenses. Secondly, to ensure that the asset values in the Balance Sheet are not overstated: an asset acquired in Year 1 is unlikely to be worth the same amount in Year 5.
It is important to appreciate that depreciation is an average or expected view of the decline in value of an asset. For example, an entity may depreciate its equipment by 15% per year. This rate should be reasonable in aggregate (ie when looking at all of its machinery), but there is no expectation that each individual item declines in value by the same amount.
Accounting Standard bodies have detailed rules on which methods of Depreciation are acceptable, and auditors will express a view if they believe the assumptions underlying the estimates do not give a true and fair view.
Taxes
When a company spends money for a service or anything else that isn't a tangible asset, this expenditure is usually immediately tax deductible, and the company enjoys an immediate tax benefit.
However, when a company buys some physical asset that will last longer than one year, like a computer, car, or building, the company cannot immediately deduct the cost and enjoy an immediate tax benefit. Instead, the company must depreciate the cost over the useful life of the asset, taking a tax deduction for a part of the cost each year. Eventually the company does get to deduct the full cost of the asset, but this happens over several years; the number of years depends on an estimate of how long it typically takes that type of asset to become effectively useless, and require a replacement. A computer may depreciate completely over five years; a factory building, over 30 years. The maximum allowable useful life estimate under U.S. income tax regulations is 40 years. Other countries have other systems, many of which remove the choice of depreciation rate and method from the company altogether. In these jurisdictions accounting depreciation and tax depreciation are almost always significantly different numbers.
Straight-line depreciation technique
Straight-line depreciation is the simplest and most often used technique, in which the company estimates the "salvage value" of the asset after the length of time over which it is depreciated, and assumes the drop in the asset's value is in equal, yearly increments over that amount of time. For example, a vehicle that depreciates over 5 years, is purchased at a cost of US$17,000, and will have a "salvage value" of US$2000 (when eventually sold after five years) will depreciate at US$3,000 per year.
If the vehicle were to be sold before the 5 year period were up and the sales price exceeded the depreciated value then the excess depreciation would be considered as income by the tax office.
If a company chooses to depreciate an asset at a different rate from that used by the tax office then this generates a timing difference in the income statement due to the difference (at a point in time) between the taxation department's and company's view of the profit.
See Also
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