Depreciation is the reduction in the value of an asset due to usage, passage of time, wear and tear, technological outdating or obsolescence, depletion, inadequacy, rot, rust, decay or other such factors.
Although depreciation recognizes the decline in an asset’s value, the cost allocation process used in accounting for depreciation bears little or no relationship to the actual market value or resale value of the asset.
It is simply an acknowledgment that a portion of the asset’s value has been used up in the process of generating revenue for your business.
Depreciating a business asset allows you to spread its purchase cost over the span of several years. It is a noncash expense that does not directly affect cash flow.
You can depreciate business assets that meet these criteria:
- The item must be used in your business or to produce income
- It must have a useful life of greater than one year
- That useful life must be finite.
Assets begin depreciating on the date they are placed in service for the business.
You can deduct only the portion of the item that you use for business.
At some point, depreciated items are expected to wear out, break down, deplete or become obsolete.
But if you spend money to extend the item’s useful life, you can deduct that as well.
Examples would be installing more memory or a bigger hard drive in your PC, or repairing, maintaining or upgrading business machinery. The Internal Revenue Service (IRS) provides several different depreciation methods.
The simplest is the straight-line depreciation method. Using the straight-line method, you simply deduct a percentage of the asset’s cost during each year of its useful life.
The IRS considers the useful life of most information technology assets, such as computers, peripheral equipment, fax machines and copiers, to be five years.
Office furnishings are considered seven-year properties.
Other depreciation techniques include:
- Declining Balance Method: Allows higher depreciation in the first year. with gradually decreasing amounts over time
- Activity Depreciation: Depreciation based on the asset’s level of activity, not time
- Units of Production Method: Useful life of the asset expressed as the number of units it is expected to produce
- Units of Time Depreciation: Applied in cases where usage of the asset is not linear from year to year
- Group Method: Groups similar assets with similar service lives and uses the straight-line depreciation method
- Composite Method: Applied to a collection of dissimilar assets that have different service lives
Whichever method of depreciation you use, you must continue using it for the life of the asset. You cannot switch to a different method of depreciation.