What Is Depreciation & How Does Depreciation Work?

Cody Cromwell
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How Depreciation Works

And Why Its Calculated?

Depreciation is an accounting concept that reflects the loss of value of an asset, over a period of time, using the concept of "ownership". The term depreciation is frequently used in connection with machinery and equipment assets. Depreciation is not an expense but a method to calculate loss in value of machines and equipment.

The accounting term depreciation has two meanings:

Actual use of funds to pay for materials and labor in

Building an asset.

Actual Use of Funds to Not Pay for Materials and Labor

In building an asset.

Depreciation is a method of accounting used to reflect the annual loss in value of plant, property and equipment. It is calculated by dividing the cost of the asset by the number of years remaining for its useful life.

The common reason for depreciation is that we want to show how much value the asset is losing each year. The theory of depreciation is to show in the accounts the actual cash outlay required to provide the asset during its useful life.

The depreciation rate is used to calculate depreciation into the future years. The higher the depreciation rate the shorter the useful life of the asset. Depreciation is used to show the continuous decline in the value of an asset due to wear and tear and the aging process.

Using Depreciation to Get a Tax Deduction

Depreciation is a way for taxpayers to recover some of the cost of an item over a determined period of time, usually over 5 to 10 years or a life of the asset.

When a taxpayer is considering the purchase of an asset which may have a useful life of more than one year, it’s important that he or she takes into account depreciation, especially if the purchase is expected to be costly.

The allowance for depreciation is available to individual taxpayers, corporations and a number of other people and entities, including sole proprietors, partners in partnerships and limited liability companies, organizations subject to the limits of section 512(a)(1) of the Internal Revenue Code, and certain cooperatives.

Depreciable Property is:

  • real property,
  • such as buildings and improvements
  • machinery and equipment
  • tangible products, components and materials, including supplies used in manufacturing

Tangible personal property, including vehicles, furniture, appliances, computers, stocks, bonds and other property.

Depreciable Cost Are

But not limited to- cost or basis, plus.

Actual direct expenses, plus.

Additional amounts allowed by other provisions of the Internal Revenue Code, including timber depletion allowance.

Reporting Depreciation for Accounting Purposes

In general, if you purchase and pay for something up-front with cash or money you’ve saved, you lose money on the transaction. This loss may be lost to taxes or the interest you may pay to save your money and is also known as depreciation.

Gains and losses are reported as an expense or income in your income statement. By law, companies must prepare and report their income and expenses according to generally accepted accounting principles (GAAP). So even if you’re personally responsible for the purchase of your equipment, its cost is still reported on your company’s income statement.

The income statement is broken down into three components: revenues, expenses and net income, which is simply revenues minus expenses. When it comes to depreciation, you’ll want to consider the following information first:

Absorption Period

The absorption period is the time required for the entire cost of your equipment to be taken into account and charged off. The value of your equipment is considered on an annual basis, and this is also called its depreciation period. When you purchase your equipment, you’ll typically be told what its depreciation period is.

Tax vs Book Depreciation Takeaway

Besides the regular tax deductions that you can obtain during tax time for your business or personal income, book depreciation also provides a limited tax deduction for your "expenses."

In a nutshell, book depreciation allows a partial tax deduction for the cost of your assets. Book depreciation is a tax benefit for the holding of assets which depreciates as you go through the life cycle of the asset. Book depreciation starts at a cost of the asset and decreases during its useful life.

The IRS has a depreciation calculator which breaks down how much your assets will be given depreciation. This free tool from the IRS is available here.

As a rule of thumb, most assets require about a 10% depreciation for most businesses. In a sense, this is like making a rough estimate about how much a regular asset will cost you in the future. The usefulness of the asset will eventually decrease and you will have to take a depreciation step to take off the item from your business or personal portfolio.

Book depreciable assets include but are not limited to:

  • Capital goods, such as machinery, computers, furniture and equipment
  • Office buildings, vehicles and other equipment
  • Computer software
  • Other investment property, such as buildings and equipment used to mine for minerals

Changes in the value of a depreciable asset during its useful life are called depreciation allowances. Depreciation allowances are claimed every year and correspond to the book value of the asset.

Requirements to Depreciate Assets

If you’ve been dealing with assets, you might have heard about depreciation. For those who don’t know, depreciation is the write off of an asset on a federal tax return which reduces the value of your asset and the income you’re taxed on.

So, it’s more of a tax deduction than a deduction or a write off.

Depreciation requires some familiarity with asset class and generally, you don’t need to be too familiar with it. You get to claim it if:

A. You own the asset – not leased

B. The asset was purchased new within the last 3 years

C. The asset is used for business and for personal use.

The Asset Must Be Depreciable

First, let’s cover the basics. An asset is anything that we own that can generate income (financial gain) over a period of time. A piece of office furniture or a packaged software application (like browser or e-mail software) would be examples of assets. The term depreciation refers to the wear and tear we experience over time, and the declining value of an asset. The monthly income from the asset is a measure of that declining revenue.

You Must Own the Asset

Assuming that every asset that you buy will appreciate in value over time is a mistake. You must own the asset and experience its depreciation before you will begin to realize depreciation.

When you make ordinary and necessary repairs, you can choose to not experience the decline in the value of the asset during the repairs.

Let’s look at the example of an automobile. When you drive the car, you are driving it. When you get it serviced, you are experiencing the depreciation.

Likewise, when you drive the car, you are not investing in it. It is an expense, not an investment. It is a depreciating asset.

This one fact is why "Mileage-Based" depreciation is not very useful in accounting for businesses. In fact, the IRS does not allow it. However, it is possible to use this calculation for tax purposes, as it is familiar to people.

Homeowner income is based on the amount of money spent on the home (referred to as "basis"). Therefore, if you have the basis but do not pay the expenses, you still experience the depreciation. The expenses are deducted from the basis, but you experience the depreciation loss.

The Asset Must Be Used in Your Business

As an owner, your job is to make sure the asset gets valuable use in your business, which means you have to know when it has been lost or damaged.

In the first year of owning an asset, your book value will generally fluctuate in the same direction as the disposal expense. Depending on the asset, this should be either an increase or a decrease.

The next year, the book value will no longer fluctuate in the same direction as the disposal expense, but rather in the opposite direction. The difference is called depreciation expense.

Please note that if you charge a fee for the use of the asset in your business, you have to add this fee into your books.

At the end of year two, the book value should be at its new determined value.

After year three, the book value will be exactly the same as its new determined value had been at the beginning of year three.

This describes the normal pattern of depreciation expense. It is assumed that you are using the asset in your business from the day of its expense until the end of the accounting period.

If you don’t use the asset in your business, you would still deduct depreciation. However, these depreciation expenses might be subtracted too many times for the asset to become totally worthless.

The Asset Must Have a Determinable Useful Life

The accounting principle that governs the recognition of the value of an asset upon its transfer by purchase, transfer, or disposition is called depreciation. The asset’s useful life is the term from a date of initial purchase to the date of disposal. Accordingly, the cost of the asset must be amortized or depreciated over the useful life, as shown in Table 1.

Since depreciation reduces the asset’s cost over time, it is commonly called amortization. Depreciation is a noncash expense that allows a business to recover the expense of an asset over the same number of years that it’s being used. Amortization and depreciation are considered ordinary and necessary business expenses. Businesses are not required to capitalize costs included in total assets recognized during the period.

Depreciation can be a useful method to recognize the expense of product life over its expected life. During the years that the product is in use, the business still incurs its cost and incurs a loss on its disposal. However, during the years that the product is not in operation, the business does not incur any loss and only recognizes the expense of its cost capitalized during the asset’s audit life.

In their simplest form, assets can be assigned one of these two depreciation methodologies:

The Useful Life of the Asset Must Be Greater Than One Year

How to Depreciate Repairs & Improvements

One of the most common questions is, how to depreciate repairs and improvements to a rental property.

If we built a new room addition and the rental listing states that the home has 3 bedrooms when it really only has 2 (the new room really is just a closet), the new room is an improvement to the rental property that should be depreciated.

If, on the other hand, we built a new 2-car garage, the addition is not an improvement when the rental listing states that the home has 2 bedrooms because the garage is not being used for any of the bedrooms.

The IRS allows property to be depreciated over the useful life of the building at an effective yearly price. You can use the effective yearly price or hedonic price to depreciate repairs and improvements to a rental property.

The hedonic price is the yearly price that the rental property would sell for if it were to sell, and the hedonic price is updated yearly. Technically, this function automatically ceases with foreclosure, bank auction, or repossession, but the IRS made an exception for a certain period to determine the hedonic price.

Example of How Depreciation Works for Repairs & Improvements

When Depreciation Starts & Ends

A company will account for the cost of an asset over the time in which it is held. When an asset is purchased or constructed, it will establish its value as a given date. From that point, all income generated from the asset will be recorded as a reduction in the value of the asset. These continual costs are called depreciation, as the asset is losing value over time.

Depreciation ends when an asset is sold or either written up or down. For an asset to be written up or down, a certain amount of appreciation or depreciation must have been recorded before the event occurred. If depreciation was not recorded, there is no reason to write up the asset, and the asset will continue to depreciate.

Companies are required to place the value of these assets in their financial statements for each year so that they cannot reverse their losses. When they sell the asset for more than what they initially paid for it, the company records a gain. When they sell the asset for less than what they paid, they record a loss.

When an asset is written down, or a loss is recorded, a book entry is made to the individual asset. This entry will then create a debit and credit in the individual asset’s accounts.

Asset Is Placed in Service

Depreciation is a non-cash expense that is recognized in the income statement as an expense. As property, machinery, or equipment is placed into service, the cost of the asset is deducted.

Costs are written-off and depreciation expense is incurred over time. It is used as an adjustment to income to show the effectiveness of an asset. The cost of the asset is depreciated using either a straight-line method or the units of production method.

Depreciation is a non-cash expense with future benefits.

Depreciation is the systematic allocation of the cost of an asset over its estimated useful life. Depreciation is the accounting process of allocating the cost of a long-lived asset over its useful life so that that portion of the asset’s cost is not currently recognizable in the income statement.

Thus, depreciation is determined by the cost of the asset, the period of use of the asset and its estimated useful life.

Depreciation can be either:

Assets are valued based on their stated or usable value. Assets are valued based on the amount or fair cost of purchasing or building them. Depreciation is the deduction of the cost of an asset over the life of the asset.

Cost of the Asset Is Fully Recovered

Calculating the depreciation of an asset is one of the tricky things to do in accounting. So if you have any confusion regarding the depreciation of an Asset, it is always advisable to seek help from a Professional, who can guide you to the exact right method.

The most frequently asked question based on the concept of depreciation is that how much is represented by the answer of the question above?

For the User, the product tag should always be the first source of information to know about the details of the product. In the case study given below, the record mentioned the details of the product and how they work.

For the Investor, depreciation is the cost over the period, which is accounted for in the net worth statement of an organization.

The net worth statement of an organization is very much necessary in understanding the financial position of the organization. The net worth statement of an organization can be very useful to know about the financial position of the organization.

The Net worth statement of any organization is used to value the historical financial position. The Net worth statement serves to reflect the worth of the assets (goods, plant, equipment) and the liabilities in a simple manner.

Depreciation is the mechanism to account for the depletion of an asset. There are various factors to consider in determining the amount of depreciation for the asset.

Asset Is Retired From Service

When equipment no longer performs the duties for which it is designed, it is said to be retired from service. When a building is no longer occupied by or even used for its original purpose, it is said to be vacant. When equipment or facilities are no longer used or are no longer considered necessary, it is said to be obsolete.

Depreciation is the same idea applied to the value of an asset. An asset loses value over time as it is used or even as it sits idle. You would want to account for all of the years the asset was in use in its value. So, to value it, you deduct the portion of depreciation.

If a building used for business loses 20 percent (at the end of the year) of its value, you would take 20 percent of the original cost to arrive at the value of the business.

Once retired from service, the previously useful asset can be resold for a higher price – its value has increased. The figure you would use to evaluate the income-generating potential of the asset that was sold would be the current value. Its value now, rather than its value last year which only takes into consideration the years it was in use.

If assets of a company are sold and the current value of its assets is more than the value of its liabilities, its owners receive a profit. This is because the value of the assets exceed the value of the liabilities.

Summary of the 7 Depreciation Methods

The basis of depreciation is the cost of the fixed asset being spread over a period of time. There are four methods for doing this:

  • Book Method
  • FIFO (First In First Out) Method
  • Weighted-Average Method
  • LIFO (Last In First Out) Method
  • Assessment of Depletion Method

Summary Table of Depreciation Methods

Depreciation is the over the course of time decrease in a assets value. It affects most assets and is mainly used for accounting when running a business. As an asset depreciates its value decreases, hence it takes in money that you put in and puts a decrease back out. This means no money is actually coming in to your business.

There are different ways that you can depreciate an asset, each with its own advantage and disadvantage. The principal method of the United States Accounting profession is called straight line depreciation. It consists of single rate steps of how much to depreciate different parts of the asset. It is simple to understand and easy to work with. Tax on asset value decreases to make the calculations easier and the depreciation at each step is the same.

The disadvantage is that it can be quite harsh on assets. For instance, if you want to buy a car outright, like a brand new car, and you want to use straight line depreciation you will have to spend a lot of money that you didn’t originally plan to do so. The other disadvantage is that it is not really popular among other industries like the textile industry. They do not use straight line depreciation because they are commodities where their cost is worked down over time. Their cost stays the same, by the end of a year they would have made a profit.

How to Choose the Right Depreciation Method

Depreciation is one the fundamentals of finance that helps you calculate the value of your firm’s assets at the end of their useful life. You can choose from two options based on your firm’s objectives – straight-line depreciation or accelerated depreciation.

Both straight-line depreciation and accelerated depreciation allow you to record the book value of your assets while allowing you to expense the cost of the asset over the useful life of the asset as opposed to recording the book value at the beginning of the asset’s life.

Straight-line Depreciation is one of the two methods of accounting for depreciable assets, and it’s the most widely used method of depreciation in small businesses.

As the name suggests, straight-line depreciation is straightforward and easy to understand. The total cost is evenly allocated to the useful life of the asset, and the value, or net book value, is used for subsequent depreciation calculations.

While straight-line depreciation is simple and easy to understand, many small businesses use accelerated depreciation because of tax considerations.

Accelerated Depreciation works similarly to straight-line except that the useful life of the asset is shortened to increase the tax deduction.

Depreciation is an easy-to-understand concept that is often explained differently by different authors and experts.

Sample Depreciation Expenses for $1,000 Computer Using Different Depreciation Methods

Choosing a Depreciation Method for Tax Purposes

Depreciation is a great business tool that allows companies to write off a portion of an asset…s cost over a specific period of time. It’s done in a very particular way, by specific methods, and for specific reasons. Though often the same reasons, there are different methods that can be used depending on the situation and therefore the best method to use in your situation. For example, some assets have different lengths of useful lives and the method in which they’re depreciated is dependent on that.

Another common reason for depreciation is the use of an asset for business, which includes motor vehicles, computers, keyboards, and furniture. But what exactly is depreciation? To put it shortly, depreciation is a way of reducing the cost of an asset over time and is applied to assets with a definite useful life.

There are three main methods that can be used for writing off an asset…s cost or depreciation:

Depreciation methods – These are the ways in which the depreciation expense is deducted from the total cost. They vary based on the type of asset because their useful lives and how the asset’s own cost is divided into separate amounts that can be deducted for depreciation.

Choosing a Depreciation Method for Book Purposes

Depreciation is a calculation that reduces income totals from an asset or account in the future to their present value or value as of a specified date.

The use of depreciation is largely determined by whether the asset was purchased for personal or business use and how long you expect to use it for. Depreciation methods allow for even tax distribution and can maximize your deductions in the years where an asset is used and is not subject to tax.

For Book Purposes, the most common and often the most appropriate of the available depreciation methods is MACRS. It provides for a uniform depreciation method for all assets used in a business. In other words, it doesn’t matter how long an asset is expected to be used as long as it was used in your business in the tax year.

If your book is for a taxable trading business, with the possible exception of a plumber or carpenter business, you would use MACRS. Use straight line deprecation if Schedule C is used as the tax book. For trades and businesses not involving a Schedule C, the user of the asset needs to use the average-usage method.

For Personal Purposes, the two most common methods of depreciation are MACRS and the straight-line method. For personal items, you will need to know which method to use.

For tax purposes, the following depreciation methods are used:

How to Claim a Tax Deduction for Depreciation

Depreciation is the process by which the value of an item slowly falls over time. Everything with a value has a depreciation figure associated with it. The "book value" is the initial value that the buyer paid for the item, and the "useful life" determines the time during which the depreciation will occur. Every business owner desires a productive business they can work on for the long term in order to keep their business financially sound. In order to keep its value, a building must be able to withstand the forces of time, and that includes snow, high winds, and fire.

Breaking down and rebuilding a building are both types of depreciation. A "building" can be a manufacturing facility, an office, a warehouse, or even a retail establishment. Some buildings have service lives of several decades, while others satisfy only the needs of a few years.

When a building is initially put into service, the cost of the building to a business is known as the "original cost." That will be generally high, but will be reduced by depreciation schedules. The depreciation of a building begins to occur as soon as the building is put into service. Whenever a building is put into service, the "residence portion" of the depreciation begins to take effect.

How to Record Depreciation for Accounting Purposes

It is necessary to record depreciation of an asset in order to accurately assess how much you have invested in an asset and the recoverable amount at the disposal of the business.

The accounting method adopted for the depreciation of assets will depend on whether that asset is factored in the balance sheet. In such case the asset will be depreciated over the accounting life. If it is not factored in then it will be depreciated over the useful life ranging from 3 to 7 years for most types of assets.

The accounting method for depreciation will also depend on the type of asset. Everything has a regular depreciation life as standard and depreciation methods that work for one asset will also work for other assets as far as the objective of the depreciation is concerned. You will find the depreciation methods given below and these depreciation methods also explain the objective of depreciation.

Depreciation by the Straight Line Method

The straight line method of depreciation means that the depreciation rate is calculated by dividing the amount to be depreciated in a year by its cost. The depreciable cost consists of the cost of the original purchase of the asset and the costs incurred during the normal wear and tear of the asset during the period of use.

Depreciation by Diminishing Returns Method

The diminishing returns method is used when the costs incurred in the initial stage of an asset’s life is relatively high and the life of the asset is also relatively long.

Prepare the Depreciation Expense Journal Entry

This example will show you how to prepare your Depreciation Expense journal entry. This example Depreciation Expense journal entry assumes the following:

{1}. You are recording income and expenses on a day-to-day basis.
{2}. You will continue to use the double-declining-balance method and will record depreciation using the double-declining-balance method.
{3}. Your company uses the straight-line method to calculate depreciation expense.
{4}. If your company decides to change from the double-declining-balance method to the straight-line method, the change will take effect for the current period or later.
{5}. If the straight-line method reduces your total depreciation expense for the period, you will record a reduction in depreciation expense in the Deduction Expense account.
{6}. If the straight-line method increases your total depreciation expense for the period, you will record an increase in depreciation expense in the Depreciation Expense account.

The Depreciation Expense account is used to record depreciation expense in a systematic and orderly way. Using the journal entry format, you will record depreciation expenses in both the period’s Depreciation Expense account and in the current year’s ending balance.

Maintain Records on the Assets

One way to take advantage of the gain on tax basis method of depreciation is to maintain records on the assets that you depreciate.

As depreciation starts with a fixed value (new), based on the asset purchase price, the basis is adjusted to a current value (amortized) at the end of each year. A method (method of depreciation) with equivalent depreciation is used during the whole life of the asset.

The method (method of depreciation) is either straight line or declining balance.

The straight line method of depreciation is used if you want to know how larger, multi-year investments will depreciate. It starts at the time the asset is placed in service and ends at the time it is fully depreciated and written away.

The declining balance method is a place where the depreciable value is spread over a number of years.

Below is an example:

Below are some of the common assets that are depreciated.

Furniture – Furniture includes any item used or required for the comfort of an office worker. Examples are:

a) Chairs and Tables

I. Chairs – Are located in workplace where work is being carried out. These chairs are used for sitting are for both personal and working purposes.

II. Tables – Are used for eye level or work level work.

Prepare a Depreciation Schedule

Depreciation is a complicated accounting method that makes it appear to investors that the company’s cost is adjusted for wear and tear – depreciation.

It allows business owners to smoothly account for the cost of its assets and the reduction in value of those assets over time. Investors become convinced by the sudden and dramatic increases in the company’s shareholders equity balance, and they, in turn, push up the price of the company’s stock, despite the fact that the company’s cost of capital doesn’t appear to change.

Depreciation is a very common accounting method. It’s used by companies everywhere – in all different kinds of industries – so many that we can’t possibly cover the topic in this article.

But for the sake of what I’m about to discuss, I’d like to focus on the business’s depreciation of material assets such as office furniture, equipment, and computer software. By tracking the value of these assets specifically, we can examine the way depreciation affects the company’s reported earnings.

How to Use QuickBooks to Track Depreciation

If you own a business, you need to understand the effects of depreciation to its fullest. Depreciation is the process of tracking the value of the assets that you have purchased for your business.

As the name suggests, the value of the asset decreases with the passage of time. As soon as you buy an asset, you have to calculate its depreciation factor which tells you about the amount of money that you’ll be spending on depreciation.

Depreciation can help in reducing your taxable profits and keeping them under the IRS limits. It also allows you to deduct the purchase cost of the asset from your company income. However, you have to be very careful while calculating the depreciation for your business assets because you could end up taking a larger taxable profit which might carry a huge tax penalty.

In this post, we’ll take a look at what depreciation really is. We’ll also look at the types of expenses that you can deduct from your company income, the calculations involved in it, as well as the different types of assets which can be depreciated under the business tax rules.

Frequently Asked Questions (FAQs): What Is Depreciation

How Does Depreciation Work?

Depreciation is the loss of value that occurs from the use of an asset over a period of time. Also known as "life" or "time value of money," the concepts of depreciation and the time value of money are common to all investing.

Asset prices, such as stocks and real estate, rise in value due to future expectations of demand and supply, along with technology and the market environment. It’s important to understand the scope of asset prices, as well as the causes for and extent of depreciation. Someone looking to invest in a property for rental purposes may be affected by the extent of depreciation.

What Is Depreciation?

Depreciation is a calculation that measures the loss in the value of a property over a period of time. It’s popularly known as the –cost of using something.” This concept is an important part of investing because it’s essential to understand the relationship between time and money. Put simply, the more time you have to invest, the more profitable your portfolio will be. The less time you have to invest, the less profitable your portfolio will be.

How does depreciation affect income?

Depreciation is an expense that is shown as a deduction on your income tax, hence reducing your taxable income.

In other words, depreciation reduces your original or replacement cost, because you cannot buy a replacement of a particular item, say, car, once and use it forever. You have to state an amount, which is a part of the actual or given value, and is called a depreciation amount. This depreciation amount is shown as an expense on your income tax.

When the booked value of an asset reduces to 50 percent or more of its value, it becomes the replacement value. This is an indication that the asset is getting old.

Every asset has its beginning value and its end or actual value. Capital expenditure on the asset is treated as depreciation income.

The depreciation under such circumstances is called a declining balance and is also known as Class Life Method.

The following are the items that can be depreciated under this method:

  • Furniture
  • Tool items
  • Non-retail motor vehicles
  • Computers
  • Business peripherals, such as ink ribbons and paper
  • Organizational equipment
  • Other equipment

For every asset, in order to choose a depreciation method, you should compare cost of purchasing, maintenance cost and life periods.

How many years do you depreciate equipment?

In the United States, most companies depreciate equipment over a period of five years. It is important to note that companies are not mandated to use a specific depreciation schedule. Firms may choose to use shorter or longer depreciation times.

Also, some companies choose to start deprecating their equipment from the moment they purchase it. This is known as accelerated depreciation. The choice of whether to use accelerated depreciation or not depends on the company’s financial situation and its tax requirements.

Since there is no inherent advantage or disadvantage to using either accelerated or straight-line depreciation, there are many firms that simply use the schedule that their accountant or CPA advised them to use.

Also, some companies will choose to further separate their calculation of depreciation expenses into differing schedules depending on the types of assets. So for example, some firms will have separate schedules for machinery and equipment. In this case, only the machinery and equipment are depreciated over the period of five years. The cost of building and real estate is not depreciated during this time period.

One point to note is that real estate and building depreciation expenses appear as a separate expense item when companies work with the annual budget.

Generally, the costs of building depreciation and the expense on site are not fully written off by depreciation expenses in any one year. Instead, the costs of building depreciation and site costs are estimated and included in the annual budget numbers when financial planning.

Why is depreciation calculated?

Depreciation is calculated to make accurate accounting records of the cost of an asset. Depreciation is calculated so that an investor knows how much money he has lost due to the declining value of his investments. In other words, it represents the lost value of an asset over a period of time. To calculate the loss of value, accountants assume that the asset will fit into its expected time of use, either as an asset or its expected useful life.

However, this does not mean that hardware will reduce in value as quickly as the owner wishes for it to. Depending on how the item is used, hardware may degrade more slowly or quickly.

The cost of hardware is also affected by business-related factors, such as the average life-span of computer hardware and peripherals.

Hardware depreciation can be calculated on a straight-line basis or on a declining balance basis (also known as accelerated depreciation). The methods of depreciation for the hardware are as follows:

Straight-line depreciation. Under this method, the depreciation amount is equal to a fixed amount (the straight-line method term) multiplied by the percentage of decline in the value of the hardware.

Declining balance depreciation. In this case, the declining balance method is the most popular method. It is based on the percentage of the remaining useful life (the declining balance rate, based on percentage of cost) for the hardware.

What types of assets are subject to depreciation?

Depreciation is a process used to reduce the value of an asset over time. It can be used for assets such as cars, computers and homes. The purpose of depreciation is to account for the use of and the lessening value of an asset as it gets older and less useful.

When a business purchases an asset, it puts it on its books, or a form of accounting. The asset or property is then said to be depreciable. The business will then track the asset as it wears down with time and accounted for its dwindling value over time.

Depreciation is one of the most important financial concepts to understand because it simplifies the way we look at things and makes it simpler to manage our money. There are two types of assets that are depreciable on the year end financial statement:

Current Assets
These assets are owned by your business as of the last trading day. For example, cash, accounts receivable and inventory are examples of current assets. These assets are considered to be more short term in nature and in the short term may be worth a lot more or less than what is shown on the financial statement.

Fixed Assets
These assets are owned by your business and are considered long term. For example, a building, machinery and equipment may be considered fixed assets. Fixed assets generally are considered to be worth more at the year end, as they depreciate less and have longer useful lives.

Bottom Line

Depreciation of an asset is the process of marking down the value of an asset and is a part of the income statement. The value of the asset is added to the cost of the asset and will decrease the profit margin of the balance sheet.

Any change in the balance of the assets will affect the profit and loss. The assets are the business resources present in the firm. The assets are of three types viz. –

Physical assets ‑ which are real and tangible assets. These can be a business’s buildings, land, vehicles etc.

Intangible assets ‑ which are non-tangible assets. This can be goodwill or a patent which is not a product.