Depreciation

Definition of Depreciation

1. Depreciation (in Accounting): A measure of the decrease in value of a tangible fixed asset during an accounting period. This decrease accounts for the asset’s wearing out, using up, obsolescence, or other reductions in its useful economic life. Computation methods vary, including:

Straight-Line Method: Equally distributing the cost of the asset over its useful life.
Diminishing-Balance Method: Reducing the book value of the asset by a constant percentage.
Sum-of-the-Digits Method: Allocating a larger portion of cost in the earlier years of the asset’s life.
Production-Unit Method: Based on the asset’s use or output.
Revaluation Method: Adjusting the asset’s value based on appraisals or market value.

Depreciation reduces the book value of an asset and is charged against an organization’s income as shown in the profit and loss account. Section 17 of the Financial Reporting Standard Applicable in the UK and Republic of Ireland and IAS 16 (Property, Plant and Equipment) are the key regulations addressing depreciation.

2. Depreciation (in Currency): A fall in the value of a currency under a floating exchange rate relative to other currencies. This can refer to daily fluctuations or long-term realignments. In fixed exchange rate systems, a devaluation or revaluation is required to change the currency’s relative value. Compare: appreciation.

Examples:

Accounting Depreciation:
- A company purchases machinery valued at $50,000 with an estimated useful life of 10 years. Using the straight-line method, the annual depreciation expense is $5,000.
- An airline has an aircraft with a book value of $15 million and uses the production-unit method. If the aircraft is expected to fly 5,000 hours and flies 500 hours in a year, the depreciation expense for the year would be proportional to the hours flown.
Currency Depreciation:
- If the USD depreciates against the EUR, the exchange rate might change from 1 USD = 0.90 EUR to 1 USD = 0.85 EUR.
- During times of economic uncertainty, investors may relocate assets to safer currencies, leading to depreciation of riskier currencies.

Frequently Asked Questions

What is the purpose of depreciation?

Depreciation allocates the cost of a tangible fixed asset over its useful life, reducing its book value and allowing businesses to match expenses with revenue generated from the asset, providing a more accurate financial picture.

How do you calculate straight-line depreciation?

Straight-line depreciation is calculated by dividing the cost of the asset, minus its salvage value, by the asset’s useful life. Formula: (Cost - Salvage Value) / Useful Life.

What is the difference between depreciation and amortization?

Depreciation applies to tangible fixed assets, while amortization applies to intangible assets. Both methods allocate the cost of an asset over its useful life.

How does currency depreciation affect businesses?

Currency depreciation can increase the cost of imports, making them more expensive, but may benefit export-oriented businesses by making their goods cheaper for foreign buyers.

When should a company re-evaluate its depreciation method?

A company should re-evaluate its depreciation method if there are significant changes in the use, output, or life expectancy of the asset, or if regulatory guidelines change.

Amortization: Allocation of the cost of an intangible asset over its useful life.
Accumulated Depreciation: The cumulative depreciation of an asset over time.
Salvage Value: The estimated residual value of an asset at the end of its useful life.
Useful Life: The period over which an asset is expected to be usable.
Impairment: A reduction in the recoverable amount of an asset below its book value.

Online References

Suggested Books for Further Studies

“Intermediate Accounting” by Donald E. Kieso, Jerry J. Weygandt, and Terry D. Warfield
“Financial Accounting: An Integrated Approach” by T. Atrill and E. McLaney
“Introduction to Financial Accounting” by Charles T. Horngren

Accounting Basics: “Depreciation” Fundamentals Quiz

### Does depreciation apply to both the building and the land it is on? - [ ] Yes, both the building and the land can be depreciated. - [x] No, only the building can be depreciated. - [ ] Depreciation does not apply to real estate at all. - [ ] Both the building and land depreciate equally. > **Explanation:** Depreciation only applies to the building itself and not the land it is located on. Land typically does not lose value over time, whereas buildings do due to wear and tear. ### Over how many years must residential property be depreciated according to tax laws? - [x] 27.5 years - [ ] 15 years - [ ] 30 years - [ ] 39 years > **Explanation:** According to tax laws, residential properties must be depreciated over a 27.5-year term. This allows for an annual deduction related to the depreciation. ### Over how many years must commercial property be depreciated according to tax laws? - [ ] 27.5 years - [ ] 30 years - [x] 39 years - [ ] 45 years > **Explanation:** According to tax laws, commercial properties must be depreciated over a 39-year term. This extended period helps distribute the depreciation deduction over a longer time frame. ### Which type of property allows for depreciation as an income tax deduction? - [ ] Personal-use property - [ ] Land - [x] Income-producing property - [ ] All types of property > **Explanation:** Depreciation can be used as an income tax deduction for businesses for properties that are used for income-producing activities. Properties used for personal purposes do not qualify for depreciation deductions. ### What must a property have for it to qualify for depreciation? - [x] A useful life of at least one year - [ ] A mortgage attached to it - [ ] An appraisal conducted every three years - [ ] Equal use between personal and business > **Explanation:** To qualify for depreciation, the property must have a continued useful life of at least one year and must be used for an income-producing activity. ### Who provides the allowance for the normal wear and tear of a piece of property? - [ ] Real estate agents - [ ] Local municipalities - [ ] Property management companies - [x] The Internal Revenue Service (IRS) > **Explanation:** The Internal Revenue Service (IRS) provides an allowance for the normal wear and tear of a piece of property, which can be deducted from taxable income through depreciation. ### When filing an annual tax report, who can claim depreciation? - [ ] Any resident of the United States - [ ] Any homeowner regardless of purpose - [x] Individuals or businesses that own income-producing property - [ ] Only those with newly built properties > **Explanation:** Only individuals or businesses that own income-producing property and meet other specified criteria can claim depreciation when filing an annual tax report with the IRS. ### Depreciation is used to offset which type of expense for businesses? - [x] Income tax liability - [ ] Mortgage interest - [ ] Utility expenses - [ ] Insurance premiums > **Explanation:** Depreciation can be used as an income tax deduction, effectively reducing the income tax liability of a business. ### Why is depreciation especially important for businesses? - [ ] It is a source of immediate revenue. - [ ] It increases the value of properties. - [x] It allows for a significant tax deduction over time. - [ ] It avoids the need for any property-related expenses. > **Explanation:** Depreciation is important for businesses as it allows for a significant tax deduction over time. This tax benefit can improve the financial condition of the business by reducing tax liabilities. ### What aspect of a property predominantly affects its depreciation schedule? - [x] Whether it is residential or commercial - [ ] The construction material used - [ ] The color of the building - [ ] The landscape quality > **Explanation:** The depreciation schedule is predominantly affected by whether the property is residential or commercial, with residential properties having a 27.5-year term and commercial properties having a 39-year term.

Thank you for diving deep into the concept of depreciation through this comprehensive guide and quiz. Keep enhancing your accounting knowledge for a successful financial career!