Legal Definition of depreciation
1 : any decrease in the value of property (as machinery) for the purpose of taxation that cannot be offset by current repairs and is carried on company books as a yearly charge amortizing the original cost over the useful life of the property accelerated depreciation : the depreciation of property that was put into use prior to 1980 which is allowed at a faster rate than normal under the depreciation rules in force before the adoption of the Accelerated Cost Recovery System straight–line depreciation : depreciation of an asset by a fixed percentage of its original cost based on its estimated life
2 : a loss in the value of property due to physical deterioration and wear or to obsolescence and lack of adaptability
Financial Definition of DEPRECIATION
What It Is
How It Works
Let's assume Company XYZ purchases a piece of machinery for $1,000,000, and that piece of machinery is expected to last for 10 years. If Company XYZ were using the straight-line method of depreciation (not accelerated), each year it would simply record on its income statement depreciation expense equal to one-tenth of the asset's cost ($1,000,000/10 = $100,000). This method would spread the cost of the asset out evenly over the life of the asset.
However, if Company XYZ uses an accelerated depreciation method, it might expense far more of the asset's cost in the first few years and expense less cost in the later years.
The most popular accelerated depreciation methods are the Sum of the Years Digits method and the Double Declining Balance (DDB) method. Let's look at the DDB method first.
The formula for Double Declining Balance Depreciation is:
Company XYZ's depreciation expense under the DDB method is $100,000 x 2 = $200,000. Company XYZ is essentially expensing 20% of the asset's cost in the first year, and in each subsequent year it will multiply that 20% by the remaining balance to be depreciated.
In year two, the value of the asset is $1,000,000 - $200,000 = $800,000, so the depreciation expense is $800,000 x 2 = $160,000. Once the depreciation value is lower than the $100,000 Company XYZ would have expensed using the straight-line method, Company XYZ will revert to the straight-line method for all remaining years.
Using the same asset example from above with Company XYZ, let's look at the Sum of the Year Digits Depreciation method.
The formula for Sum of the Years Digits Depreciation is:
(Years of useful life left / (10+9+8+7+6+5+4+3+2+1)) x (original cost - salvage value)
In year 1, Company XYZ's depreciation expense using the Sum of the Years Digits method would be:
(10 / (10+9+8+7+6+5+4+3+2+1)) x ($1,000,000 - $0) = $181,818
Note that no matter which accelerated depreciation method Company XYZ uses, the total amount of depreciation expense over time will be the same. The method of depreciation chosen by the company is largely at the discretion of the company's management.
Why It Matters
When a company uses an accelerated depreciation method, it lowers the value of its total assets on its balance sheet earlier in the life of those assets. Many companies employ accelerated depreciation methods when they have assets that they expect to be more productive in their early years.
Accelerated depreciation helps companies shield income from taxes -- after all, the higher the depreciation expense, the lower the net income. High depreciation expenses recorded now, however, mean less depreciation expenses recorded later -- thus higher net income and taxes at the end of the asset's useful life. Essentially, this means that accelerated depreciation defers taxes for companies rather than helps companies avoid taxes.
Companies with large tax burdens might favor accelerated depreciation methods more -- even if using those methods results in lower net income -- because the cash saved in taxes can be reinvested in the business or given to shareholders.
Investors should take the time to understand the assumptions and methods companies use to calculate depreciation.
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