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Almost every business must invest in some major equipment, vehicles, machinery, fixtures or furniture in order to operate. Some businesses will require assets such as land, a building, patents, or franchise rights. Major assets that will be used in your business for more than a year are known as "capital assets" and are subject to special treatment under the tax laws. Most importantly, you generally can't deduct the entire cost of acquiring such an asset in the year you acquire it.
Why not? Because one of the goals of accounting is to accurately measure a business's gross income, expenses, and net income (earnings) during a given period of time, usually a year. If a business were allowed to reduce one year's gross income by an expense deduction for the total cost of an item that will be used for several years, the result would be an understatement of earnings in the year the asset was purchased, and an overstatement of earnings during the following years.
It follows that, for "capital assets" (assets that have a useful life of more than one year), the cost must be written off (that is, depreciated or amortized) over more than one year.
Theoretically, the cost of an asset should be deducted over the number of years that the asset will be used, according to the actual drop in value that the asset will suffer each year. At the end of each year, you could subtract all depreciation claimed to date from the cost of the asset, to arrive at the asset's "book value," which would be equal to its market value. At the end of the asset's useful life for the business, any undepreciated portion would represent the salvage value for which the asset could be sold or scrapped.
Since the actual drop in value of each business asset would be difficult and time-consuming to compute (if indeed it could be computed at all), accountants use a variety of conventions to approximate and standardize the depreciation process.
For example, the straight-line method assumes that the asset depreciates by an equal percentage of its original value for each year that it's used. In contrast, the declining balance method assumes that the asset depreciates more in the earlier years. The following table compares the depreciation amounts that would be available under these two methods, for a $1,000 asset that's expected to be used for five years and then sold for $100 in scrap.
|Straight-Line Method||Declining-Balance Method|
|Year||Annual Depreciation||Year-End Book Value||Annual Depreciation||Year-End Book Value|
|1||$900 x 20%=$180||$1,000-$180=$820||$1,000 x 40%=$400||$1,000-$400=$600|
|2||$900 x 20%=$180||$820-$180=$640||$600 x 40%=$240||$600-$240=$360|
|3||$900 x 20%=$180||$640-$180=$460||$360 x 40%=$144||$360-144=$216|
|4||$900 x 20%=$180||$460-$180=$280||$216 x 40%=$86.40||$216-$86.40=$129.60|
|5||$900 x 20%=$180||$280-$180=$100||$129.60 x 40%=$51.84||$129.60-$51.84=$77.76|
As you can see, the straight-line method results in the same deduction amount every year, while the declining-balance method results in larger deductions in the first years and much smaller deductions in the last two years. One implication of this system is that if the equipment is expected to be sold for a higher value at some point in the middle of its life, the declining balance method can result in a greater taxable gain that year because the book value of the asset will be relatively lower.
To understand the depreciation rules and conventions that the IRS requires you to use for tax purposes, you need to know: