The Basics of Depreciation

Published: 19th July 2006
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Definition



Depreciation is the financial aspect of the decrease in value of any asset. This decrease in value occurs through use, wear and tear, and age.



When you purchase a new lawnmower, it is worth the price you paid, obviously. Theoretically, you could turn around and sell it for the same price you just paid for it. However, the first time you mow your lawn with it, it is no longer worth as much. No one would buy it for the same price you paid because they could get the same model for the same price, unused. If you want to sell it, you'll have to go for a lower price. The difference between the price you paid and the price you could now sell it for represents the amount of depreciation your lawnmower has accrued.



In this example, depreciation was a result of use. Depreciation can also occur because of wear and tear. After the first mowing with a new lawnmower, it's basically good as new, with just a few grass stains. But after its fifth year of use, the handle is a little loose, the bag has a tear and it cuts uneven rows. Though it still works, and it has value to you because a new one would cost a lot more than just using the old one, its value has seriously decreased because of all the wear and tear.



One more means for depreciation is age. When you purchased your lawnmower five years ago, it was a new model with all the latest features. But now they're selling robotic lawnmowers. Your model is obsolete. Because of its obsolescence, it is worth a lot less than it was when you bought it.



Calculating Depreciation



There are many methods by which depreciation can be calculated. Some of these include:





  • Straight-line depreciation


This method assumes that the asset will decrease in value at a constant rate.





  • Declining-balance depreciation


This method assumes that the asset will depreciate more at the beginning of its life than towards the end.





  • Activity depreciation


This method uses the activity or use of an asset to calculate its depreciation rather than calculating depreciation as a function of time.





  • Sum of years digits depreciation


This method gives you a number somewhere between those of the straight-line and declining-balance methods



Effects and Implications of Depreciation





Not every asset will depreciate over time, in fact some appreciate. Appreciation is the opposite of depreciation. A home is an asset that appreciates. It generally increases in value over its lifetime, or over the lifetime you own it. Land also appreciates. For this reason, purchasing investment property can be a valuable addition to the positive side of your cash flow.



In the business world, a company can receive tax deductions for the depreciation of their assets. A company car depreciates and the company receives a tax deduction proportional to the depreciation, eventually receiving the full value of the car in tax deductions over its lifetime.



Depreciation is an important financial principle to understand. An understanding of it can help you get the greatest benefit out of your assets at home or at work.



Emily Lyon is a client account specialist at 10x Marketing. Visit One Minute Millionaire to learn more about depreciation and how to get the most out of your assets.




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