Depreciation is the method of allocating costs of tangible assets over its useful life. Depreciation always on long term assets, which have more than one year useful life. Depreciation on long term assets apply for both tax and accounting purposes.
Usage of Depreciation
For Accounting Purpose, it helps to determine that how much asset value has been used.
For Tax purpose, it helps to determine that how much cost of tangible asset can be deducted from its business expenses.
According to IRS rule, it is mandatory to depreciate long term tangible assets. IRS Rule clearly indicates that
- In which method long term tangible assets should be depreciated and
- When the depreciation process takes place
- What is the asset nature
- How long it will have a useful life
Why it is used in accounting
Depreciation is used in accounting because it helps to match the expenses of an asset to the revenue earned from that asset.
Assuming the company is using a straight line method.
Acquire a plant (Long term tangible asset) amount $100,000 having useful life 10 years. It will be depreciated over 10 years. Every accounting period the company spending $10,000. The company will match the revenue earned from the plant with the expenses incurred on it.
During the infamous Russian ruble crisis in 1998, the ruble lost 25% of its value in just a day. So we can say that, Currency can be depreciated or lost their value.
During the housing crisis of 2008, Las Vegas homeowners faced depreciated or lost value of their home more than 50%. Therefore, it is proved that real estate can also be depreciated.
Assumptions before Depreciation
There are several critical assumptions made before the calculation of depreciation. Management has to make a decision on critical assumptions. Three major assumptions are as followings;
- What method and rate of depreciation would be used
- What is the useful life of the asset
- What would be the scrap or salvage value of the asset