Assets, such as buildings and cars, depreciate over time and are prorated over their expected life. Depreciation is calculated differently for profit and loss schedules and income tax. Depreciation can be calculated using a straight-line or accelerated method. Real estate assets are calculated differently and require the deduction of the land value from the full purchase price.
An asset is a tangible item that has a monetary value, such as a building, car, computer, or bookshelf. Most assets wear out and diminish in value, or depreciate, over time. If a company buys an asset that has a life expectancy of more than one year, it cannot write off the full cost as an expense in the year it is purchased. Instead, the cost is prorated over the expected life of an item, and that prorated amount is deducted as depreciation on the asset.
In accounting, an asset is depreciated differently for the profit and loss schedule than it is for income tax. Depreciation of assets for business purposes is based on the actual time the company expects to use the item, while depreciation for tax purposes uses a life expectancy set by property class and determined by the government tax authority. For example, a company may buy a car that it intends to use for only three years, so the depreciation of the assets will be spread over three years for the income statements. However, the tax code may require a vehicle to be depreciated over five years, so a different calculation is used when preparing tax forms.
Asset depreciation can be calculated using a straight-line method or some form of an approved accelerated method. The straight line is relatively simple to calculate; The cost of the item is divided by the number of years it is expected to last and an equal amount of depreciation or cost deduction is taken each year. Using this method, an item that costs $5,000 US dollars (USD) and has an expected useful life of five years will be deducted, or depreciated, at a rate of $1,000 USD per year. If the item is purchased or placed in service at any time other than the first of the year, then an adjustment must be made in the first and last years of the asset’s life.
Accelerated forms of depreciation are based on established formulas or charts, and are frequently changed by legislative bodies. In times of economic prosperity, the amount of acceleration allowed may be reduced and the life expectancy of the asset class may be extended. During economic downturns, governments can increase the amount of initial depreciation allowed and shorten class life expectancies to encourage companies to increase spending on real estate assets.
In the US, the full cost of the asset is allowed to be deducted, while the UK and Canada assign a residual value to an item that cannot be deducted. If a car costs $10,000 USD and has a salvage value of $1,500 USD, then the depreciation of the assets will be limited to $8,500 USD in those countries. Canada and the United States allow depreciation as an income tax deduction. In the UK, depreciation is calculated solely for the purpose of determining a company’s net worth. Depreciation is added back to net income for tax purposes, and a percentage of the cost, called the capital allowance, is deducted on the return.
The calculation of depreciation for real estate assets is different and is not based on the cost of the entire property. The universal assumption is that the land the buildings stand on will last forever and therefore depreciation is not allowed. However, structures will wear out over time and need to be restored or replaced. To calculate depreciation of real estate assets, most countries require that the value of the land be deducted from the full purchase price to calculate the portion allocated to depreciable structures.
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