Depreciation is an annual deduction that businesses can claim for the cost of fixed assets, such as vehicles, buildings, machinery, and other equipment. According to tax law, depreciation is defined as a reasonable deduction for the wearing down and/or obsolescence of those fixed assets. It is included on income statements as an expense for accounting purposes.
The cost of assets that are totally consumed within an accounting period will be recognized as an expense within that period. When an asset is not totally consumed within a single accounting period—as is typically the case with fixed assets—the cost of the asset must be allocated as an expense over the periods in which the asset is consumed. Depreciation arises from this attempt to assign asset cost to the periods of asset consumption. The depreciation for an asset in a period is simply an estimate of the portion of the original cost to be assigned as an expense to the period. A similar concept is depletion, which is applied to the extraction of natural resources in recognition of the fact that a certain part of the natural resource has been consumed during a given period.
MISCONCEPTIONS ABOUT DEPRECIATION
Since depreciation is an allocation of cost over accounting periods, it is not directly connected to market value—or the amount that the asset would be worth if it were sold. The book value of an asset, computed as the actual cost minus the accumulated depreciation, is simply the unallocated cost of the item. The pattern of depreciation is fixed, and does not respond to changing market conditions.
Depreciation does not involve any cash flow. This is clearest in the simple case of an asset acquired entirely by cash payment. Although the initial purchase is a cash flow, the subsequent allocation of part of the cost as a period expense involves only an accounting entry. Depreciation is not intended as a mechanism to provide for replacement of the asset. There are no cash flows associated with depreciation, and there is no connection with any cash accumulated for replacement of the asset. The asset may or may not be replaced—this is a capital budgeting decision that is immaterial to the recognition of expense.
Because depreciation is an expense but has no associated cash flow, it is sometimes described as being "added back" to arrive at cash flow for the firm. This gives the impression that depreciation is somehow a source of cash flow. The "adding back," however, is simply a recognition that no cash flow occurred, and depreciation cannot supply cash.
METHODS OF DEPRECIATION
The concept and relevance of allocating the portion of the original cost of an asset "used up" in a period as an expense of the period is clear. In many practical cases, however, the proportion of cost to be allocated as an expense of a particular accounting period can only be estimated. Allocating cost as an expense requires estimation of the useful lifetime of the asset (which may be expressed in terms of time or in terms of units of production), and any residual or salvage value. These estimates must reflect obsolescence, and may be dependent on maintenance, rate of use, or other conditions. While some guidelines exist, they are in the form of suggested ranges, and the estimate may be strongly influenced by industry practice. The choice of depreciation parameters and methods is made by management. For a given type of asset, the estimates may differ widely among firms or industries.
In recognition of the difficulties of such estimation, generally accepted accounting principles (GAAP) allow wide discretion in the depreciation method used. Where the productive life of an asset can be expressed in terms of units of production, the units-of-production method can be applied. Under this approach, the amount of depreciation for an accounting period is the depreciable value of the asset (actual cost minus any residual value), divided by the (unit) lifetime, and multiplied by the units produced in the period; depreciation in a period will thus be a function of production in the period.
Straight-line depreciation is the allocation of equal depreciation amounts to accounting periods over the life of the asset. The straight-line depreciation amount is the depreciable value divided by the lifetime in accounting periods. For example, for an asset with a four-year useful life, yearly depreciation would be 25 percent of its depreciable value. An argument against this procedure is that obsolescence and other factors are not linear over time, but rather reduce the usefulness or productivity of an asset by larger amounts in early years.
Accelerated depreciation methods recognize this nonlinear decrease in productivity by assigning more depreciation to early periods, and less depreciation to later periods. The double-declining balance accelerated method allocates depreciation as a constant percent equivalent to twice the straight-line rate, but applies this to the book value of the asset. For an asset with a four-year useful life, yearly depreciation would be two times 25 percent or 50 percent of book value. The final year of double-declining balance depreciation, however, is the amount necessary to equate book value to residual value. Sum-of-years' digits accelerated depreciation is computed by multiplying depreciable value by the remaining periods of useful life at the start of the period divided by the sum of the digits in the original useful life.
Depreciation is an expense, and it affects taxes by reducing taxable income. A firm may use different depreciation treatments for tax purposes and for financial statements. Typically, straight-line depreciation would be used for financial reporting because it produces more consistent earnings and is easily understood. An accelerated depreciation treatment would be chosen for tax accounting because the higher depreciation in early periods results in lower taxable income, and shifts tax payment to later periods when lower depreciation results in higher taxable income. This is solely a timing advantage. The total amount of taxes paid is not reduced, but a portion of the payments is shifted to later periods.