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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Depreciation

What it is:

Depreciation is a term used for tax and accounting purposes that describes the method a company uses to account for the declining value of its assets.

How it works (Example):

An asset acquired in 2005 is unlikely to be worth the same amount five years later; most of the time, the asset will have worn down, been depleted, or become obsolete.

While there are many ways to calculate depreciation, the most basic is the "straight line" method. Under this method, the depreciation of a given asset is evenly divided over its useful lifetime. The method entails dividing the cost of the asset (minus its salvage value) by its estimated useful life.

For example, let's say Company XYZ bought a machine that helps them produce widgets. The machine cost $30,000 and is expected to last 10 years. It's "salvage value" (the amount the machine is worth after 10 years of use) is $3,000. In this particular case, Company XYZ would take a non-cash charge of $2,700 per year to account for the asset's annual depreciation [($30,000 - 3,000) / 10 = $2,700].

Why it Matters:

Neither depreciation (or its related concept, amortization) will directly affect the cash flow of a company as it is a non-cash expense. The company is not spending money as a result of an assets depreciation, it just wouldn't be worth as much should the company be liquidated.

As most assets age, they decline in value. Depreciation is a term used for tax and accounting purposes that describes the method that a company uses to account for the declining value of its fixed assets (or tangible assets that have an estimated useful life of one year or longer). Several different methods are commonly used to account for depreciation. These include:

 

  • Straight Line: Using this method, the depreciation of a given asset is evenly divided over its useful lifetime. The method entails dividing the cost of the asset (minus its salvage value) by its estimated useful life. For example, let's say a fixed asset costs $30,000, is expected to last 10 years, and its "salvage value" is $3,000. In this particular case, a company would take a non-cash charge of $2,700 per year to account for the asset's annual depreciation. ($30,000 -3,000) / 10 = $2,700
  • Accelerated Depreciation: Using this method, the greatest depreciation deductions occur in the first years after an asset is purchased.
  • Capitalized: Using this method, a particular asset is never depreciated.
  • Expensed: Using this method of depreciation, the asset is fully depreciated in the first year.
  • 150% Declining Balance: This method of depreciation uses 150% of the straight-line value for the first year. The same percentage is then applied to the residual balance each subsequent year.
  • Double Declining Balance: This method uses twice the straight-line percentage for the first year. The same percentage is then applied to the balance each subsequent year.
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