Depreciation is a method of reallocating the cost of a tangible asset over its useful life span of it being in motion. Businesses depreciate long-term assets for both tax and accounting purpose. The former affects the balance sheet of a business or entity, and the latter affects the net income that they report. Generally the cost is allocated, as depreciation expense, among the periods in which the asset is expected to be used. This expense is recognized by businesses for financial reporting and tax purposes. Methods of computing depreciation, and the periods over which assets are depreciated, may vary between asset types within the same business and may vary for tax purposes. These may be specified by law or accounting standards, which may vary by country. There are several standard methods of computing depreciation expense, including fixed percentage, straight line, and declining balance methods. Depreciation expense generally begins when the asset is placed in service. For example, a depreciation expense of 100 per year for five years may be recognized for an asset costing 500.
In determining the profits (net income) from an activity, the receipts from the activity must be reduced by appropriate costs. One such cost is the cost of assets used but not immediately consumed in the activity. Such cost so allocated in a given period is equal to the reduction in the value placed on the asset, which is initially equal to the amount paid for the asset and subsequently may or may not be related to the amount expected to be received upon its disposal. Depreciation is any method of allocating such net cost to those periods in which the organization is expected to benefit from use of the asset. The asset is referred to as a depreciable asset. Depreciation is technically a method of allocation, not valuation, even though it determines the value placed on the asset in the balance sheet.
Any business or income producing activity using tangible assets may incur costs related to those assets. If an asset is expected to produce a benefit in future periods, some of these costs must be deferred rather than treated as a current expense. The business then records depreciation expense in its financial reporting as the current period's allocation of such costs. This is usually done in a rational and systematic manner. Generally this involves four criteria:
Cost generally is the amount paid for the asset, including all costs related to acquisition. In some countries or for some purposes, salvage value may be ignored. The rules of some countries specify lives and methods to be used for particular types of assets. However, in most countries the life is based on business experience, and the method may be chosen from one of several acceptable methods.
Accounting rules also require that an impairment charge or expense be recognized if the value of assets declines unexpectedly. Such charges are usually nonrecurring, and may relate to any type of asset. Many companies consider write-offs of some of their long-lived assets because some property, plant, and equipment have suffered partial obsolescence. Accountants reduce the asset's carrying amount by its fair value. For example, if a company continues to incur losses because prices of a particular product or service are higher than the operating costs, companies consider write-offs of the particular asset. These write-offs are referred to as impairments. There are events and changes in circumstances might lead to impairment. Some examples are: