Why Do Businesses Depreciate Their Assets?

by Deborah Barlowe; Updated September 26, 2017
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A business depreciates assets to gauge its performance during a defined period of time, an accounting period, and to accurately report earnings or losses to the Internal Revenue Service, IRS. A business chooses a depreciation method to use in the preparation of its own financial statements, but the IRS dictates the method of depreciation an accountant must use when filing a business’s federal taxes. Even though the accounting methods may differ, the same pieces of information factor into the determination of an asset’s depreciation, including the asset’s basis, useful life and salvage value.

Depreciation

A business depreciates its fixed assets, things used by the company in the execution of its business for one year or more, over the course of their useful lives. In other words, a business reduces the book value of a fixed asset every year to reflect the item’s diminished worth until the asset retains no quantifiable value, or becomes worthless in terms of the business’s accounting.

Depreciation impacts a company’s income statement and balance sheet. To depreciate an asset, an accountant transfers a portion of the item’s value from the asset category of a company’s balance sheet to the line item “depreciation expense” on the business’s income statement.

Basis

An asset’s basis represents the amount a business will depreciate over the course of the asset’s life, minus an assigned salvage value. An asset’s basis equals the sum of all costs associated with getting the asset readied for operation within the business, including monies paid in cash, trade or service, sales tax, commission, shipping, installation and testing.

Useful Life

A business determines an asset’s useful life by estimating the number of years it will take for the asset to lose all of its value because of decay, obsolescence, continued use or destruction. A business must establish a useful life for an asset or it cannot depreciate the item. An asset’s useful life begins when the business places the asset in service, meaning when the business starts to use the asset as part of its production, and ends when it no longer retains book value, even if the company continues to use the asset.

For tax purposes, the IRS assigns the length of an asset’s useful life in IRS Publication 946. The IRS assumes an asset retains no salvage value when it reaches the end of its prescribed useful life.

Depreciation Methods

Generally speaking, a given depreciation method is one of two types: straight line or accelerated. Straight-line depreciation allows a business to deduct the same portion of an asset’s value from its balance sheet during every year of the asset’s determined life. Comparatively, an accelerated method of depreciation allows a company to deduct a greater amount in the asset’s early years of life and lesser amounts toward the end of the asset’s useful life.

Unless otherwise allowed per IRS Publication 946, the IRS requires a business to use the modified accelerated cost recovery system to figure the depreciation of a fixed item for tax purposes. If a business uses straight-line depreciation when preparing its financial statements, the amount of an asset’s depreciation in a given year will differ from the amount recorded on the business’s taxes, but will equal the same total over the course of the asset’s lifetime.

About the Author

Deborah Barlowe began writing professionally in 2010. With experience in earning securities and insurance licenses and having owned a successful business, her articles have focused predominantly on finance and entrepreneurship. Barlowe holds a bachelor’s degree in hotel administration from Cornell University.

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