What is de­pre­ci­a­tion? Starting off with the basics

Since the majority of a company's assets such as furniture, machines, or buildings lose in value over the course of their useful life, they can only be used for a limited time. Other in­tan­gi­ble assets such as software, licenses, patents, or blue­prints, and various current assets such as partially or fully finished goods or even company shares, may also suffer from market price decreases in the form of value di­min­ish­ments as they become obsolete. To trace such losses in balance sheets, they must always be recorded by the company’s ac­count­ing de­part­ment. All this is nowadays known as de­pre­ci­a­tion.

De­pre­ci­a­tion is an in­dis­pens­able part of ac­count­ing and tax law. However, the term often causes confusion among young en­tre­pre­neurs, who struggle not only to find the dif­fer­ence between straight-line and declining balance methods of de­pre­ci­a­tion, but also have dif­fi­cul­ties in dif­fer­en­ti­at­ing between assets which can and cannot be written off. Find the answers to these and many other question below.

The wear and tear of computers, office furniture, machines, cars, or even buildings in your everyday business ac­tiv­i­ties is a natural process causing various decreases in value, which must be sub­se­quent­ly recorded in your accounts as de­pre­ci­a­tion. Such wear and tear is of great im­por­tance both in a com­mer­cial and fiscal sense.

Recording de­pre­ci­a­tion for com­mer­cial purposes is a matter of pre­sent­ing company assets and their cor­re­spond­ing value di­min­ish­ments in a correct manner by means of balance sheets and other similar financial state­ments. On the other hand, tax de­pre­ci­a­tion offers the pos­si­bil­i­ty of reducing the amount of taxable income reported by a business. However, these two processes are not always connected.

In principle, de­pre­ci­a­tion can either be planned and unplanned. The former, time-based method, is the result of scheduled, regular value di­min­ish­ments, whereby the total value of an asset is divided by the estimated number of years of its useful life and de­pre­ci­at­ed in ac­cor­dance with this cal­cu­la­tion method. If an asset’s useful life is un­de­ter­minable (which is often the case with various licenses or other similar in­tan­gi­ble ac­qui­si­tions), it is generally scheduled for ten years.

De­pre­ci­a­tion of company assets can be caused by factors such as:

• Natural wear and tear
• Expiry of rights or licenses
• External forces (me­te­o­ro­log­i­cal, for instance)
• Technical progress

It is not only this scheduled de­pre­ci­a­tion cal­cu­la­tion method, but also various unplanned de­pre­ci­a­tion types which pertain to current assets. If a machine endures un­ex­pect­ed, un­re­pairable damage or suffers a loss in its market value caused by changes in stock market shares, you can subtract re­spec­tive de­pre­cia­ble amounts from the asset’s total value during any given financial year.

In principle, every loss in an asset’s value must be taken into account. It is, however, primarily a question of de­pre­ci­a­tion caused by wear and tear, or in other words, the natural de­te­ri­o­ra­tion of objects with a limited useful life, the purchase or pro­duc­tion costs of which can be fully written off during this period. Tangibles such as office machinery, Persian carpets, or even entire factory sites and in­tan­gi­bles such as licenses, computer programs, or rights show just how wide the range of de­pre­cia­ble assets actually is.

Since each financial year must generally include de­pre­ci­a­tions on assets with limited useful life, the annual cal­cu­la­tion of de­pre­ci­a­tion is the most common when assessing value di­min­ish­ments of company assets.

In some cases, however,  so-called unit-of-pro­duc­tion de­pre­ci­a­tion is also a possible cal­cu­la­tion technique. In this de­pre­ci­a­tion method, the asset’s value di­min­ish­ment is cal­cu­lat­ed on the basis of its ex­ploita­tion. A typical example of this is a truck, the value of which is assessed according to its mileage. This cal­cu­la­tion method is therefore not based on the asset’s period of use, but rather on its overall per­for­mance (just like the truck has been assessed according to the distance it covered).

Straight-line de­pre­ci­a­tion is the most common of all time-based de­pre­ci­a­tion methods. Here, the asset’s carrying value is evenly spread over its entire recovery period. What this assumes is that the asset is exploited at the same rate during each of its recovery period years.

In other words, the de­pre­cia­ble amount remains the same for each year of the asset’s useful life apart from the ac­qui­si­tion year, during which the asset’s value di­min­ish­ment is assessed on the basis of the month in which it was obtained (for instance, if the asset was purchased in April, then the first three months are not taken into con­sid­er­a­tion when cal­cu­lat­ing the de­pre­ci­a­tion value).

As the term “ac­cel­er­at­ed de­pre­ci­a­tion” may already suggest, when using this cal­cu­la­tion technique, the annual de­pre­ci­a­tion amounts increase during each of the asset’s recovery period years. However, this de­pre­ci­a­tion method is rarely used, as it is tra­di­tion­al­ly only suited for fa­cil­i­ties, which generate greater income year after year (wineries).

The declining balance method of de­pre­ci­a­tion is closely related to this. In this method, the amounts that you subtract from the asset’s value are con­tin­u­ous­ly reduced over the course of its recovery period. Annual de­pre­ci­a­tion values therefore start at a higher level and then gradually decrease. This method, primarily aiming to promote in­vest­ment, was tem­porar­i­ly approved for this very purpose during the global financial crisis of 2008.

The declining balance method of de­pre­ci­a­tion, which sets a fixed de­pre­ci­a­tion rate (20%, for instance) on the re­spec­tive book value, follows a geometric de­pre­ci­a­tion sequence in the process of cal­cu­la­tion. In addition to this, there is also an arith­metic de­pre­ci­a­tion sequence, in which the book value, as its name suggests, is de­ter­mined using a declining numerical sequence.

The current tax de­pre­ci­a­tion system of the United States – MACRS (Modified Ac­cel­er­at­ed Cost Recovery System) – consists of two de­pre­ci­a­tion systems: the General De­pre­ci­a­tion System (GDS) and the Al­ter­na­tive De­pre­ci­a­tion System (ADS), which provide different methods and recovery periods when cal­cu­lat­ing de­pre­ci­a­tion de­duc­tions, one of them con­cern­ing tax-deducible in­vest­ment expenses. These are mostly related to business assets. The amount of de­duc­tions on in­vest­ments depend on the type of asset.

Not all company assets cost several thousand dollars. Items, which have been acquired or produced for smaller amounts are con­sid­ered low-value or low-cost assets. Classic examples are coffee machines, mobile phones, or even in­di­vid­ual office furniture.

The IRC states that, as a de­pre­ci­a­tion deduction, there should be a rea­son­able allowance for the wear and tear of property used in a trade or business. Although it does not define the allowable value of low-value assets, the de minimis safe harbor election gives taxpayers the op­por­tu­ni­ty to de­pre­ci­ate according to the following thresh­olds:

• Deduct amounts up to $5,000 for those who have an ap­plic­a­ble financial statement, or
• up to $2,500 for those who do not have an ap­plic­a­ble financial statement on the total amount paid to acquire, produce, or improve tangible property, provided certain re­quire­ments are met.

• What is a de­pre­ci­a­tion? De­pre­ci­a­tion records the loss of value of in­di­vid­ual assets, i.e. the amount by which in­di­vid­ual assets have been reduced
• The current tax de­pre­ci­a­tion system in the United States is regulated by MACRS (Modified Ac­cel­er­at­ed Cost Recovery System) by the United States Internal Revenue System (IRS)
• There are two basic de­pre­ci­a­tion types: planned and unplanned de­pre­ci­a­tion
• The most common de­pre­ci­a­tion methods are time- and per­for­mance-based
• Special rules apply to low-value assets
• The Table of Class Lives and Recovery Periods is a de­pre­ci­a­tion table providing in­for­ma­tion on the rec­og­nized useful lives of assets

Click here for important legal dis­claimers.