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Understanding the depreciation of fixed assets can help business owners make better decisions when it comes to handling their fixed assets.
Depreciation of fixed assets is a crucial process that businesses undertake to gradually reduce the recorded cost of their fixed assets over time. Fixed assets such as buildings, furniture, and office equipment can be depreciated, with the exception of land. The primary objective of depreciation is to match a portion of the cost of a fixed asset to the revenue that it generates. This is a requirement under the matching principle in accounting, which mandates companies to record revenues with their associated expenses in the same reporting period.
Through the depreciation of fixed assets, companies can reflect the declining value of these assets over time on their balance sheets. This gradual decline in the carrying amount of fixed assets has a net effect of reducing the value of these assets on a company’s balance sheet. It is challenging to directly link a fixed asset with a revenue-generating activity, which is why companies incur a steady amount of depreciation over the useful life of each fixed asset. By the end of its useful life, the remaining cost of the asset in the company’s records will only be its salvage value. The depreciation of fixed assets is a key factor in a company’s financial statements, and it is important to understand how it works to fully appreciate a company’s financial health.
What Kind of Assets to Depreciate?
When it comes to the depreciation of fixed assets, it’s important to make smart decisions about which assets to include in the process. Depreciating all assets may not be the best strategy since short-term assets that don’t stay in the business for long should not be depreciated. Additionally, assets with lower values may not need to go through the depreciation process, although they should still be tracked.
To ensure compliance with the IRS guidelines for the depreciation of fixed assets, it’s crucial to understand the specific depreciation life cycles for different types of assets. For instance, real estate or property has a depreciation life cycle of 27.5 years, while non-property fixed assets like vehicles and computers have a life cycle of 5 years. If any assets have a shorter lifespan than the designated depreciation period, it may not be worth depreciating them. Therefore, it’s essential to evaluate each asset individually and determine whether depreciation is necessary based on its expected useful life.
What Factors Impact Depreciation?
The most critical factor to consider is the useful life of the asset, which refers to the period during which the asset is expected to provide economic benefits. Determining the useful life of an asset involves assessing factors such as physical wear and tear, technological advancements, and market demand. For example, a computer’s useful life might be shorter than that of a building due to technological advancements in the industry.
It’s also crucial to consider the salvage value of an asset. Salvage value is the estimated value of an asset at the end of its useful life, and it’s used to determine the total cost of the asset. For example, if a computer has a useful life of three years and an estimated salvage value of $500, its total cost would be the purchase price minus the salvage value, and that figure would be divided by three to determine the annual depreciation expense.
Now you can calculate its depreciation over that period. Depreciation can be calculated using several methods, such as the straight-line method, accelerated depreciation method, or units-of-production method. These methods determine how much of the asset’s value should be allocated to each year of its useful life.
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