Your company may purchase long-lived assets such as property, plant and equipment that you depreciate over their useful lives. Depreciation is how the Internal Revenue Service allows you to expense part of an asset’s cost over a number of years.
Straight line basis is a method of calculating depreciation and amortization. Also known as straight line depreciation, it is the simplest way to work out the loss of value of an asset over time. Straight line basis is calculated by dividing the difference between an asset’s cost and its expected salvage value by the number of years it is expected to be used. Under most circumstances, computer software is classified as an intangible asset because of its nonphysical nature. However, accounting rules state that there are certain exceptions that permit the classification of computer software, such as PP&E (property, plant, and equipment).
Assets like property, plant, and equipment (PP&E) are tangible assets. While software is not physical or tangible in the traditional sense, accounting rules allow businesses to capitalize software as if it were a tangible asset. However, there are times when software should not be considered a long-term asset. In this article, we’ll review the accounting standards that are in place to classify computer software.
Tangible Asset, Useful Life, and the IRS
Companies use depreciation for physical assets, and amortization forintangible assetssuch as patents and software. Both are conventions that are used to expense an asset over a longer period of time, not just in the period that it was purchased. In other words, companies can stretch the cost of assets over many different periods, enabling them to benefit from the asset without deducting the full cost from net income (NI).
Also, the asset may become too expensive to operate profitably after a period of time. For example, a machine may be able to process 100 units per hour, and can theoretically do so for the next 20 years. However, its useful life may be only 5 years, since it can be replaced at that time by a machine that can process 500 units per hour.
Determining monthly accumulated depreciation for an asset depends on the asset’s useful lifespan as defined by the IRS, as well as which accounting method you use. The cumulative depreciation of an asset up to a single point in its life is called accumulated depreciation.
The carrying value of an asset on a balance sheet is the difference between its purchase price and accumulated depreciation. A business buys and holds an asset on the balance sheet until the salvage value matches the carrying value.
This graph is deduced after plotting an equal amount of depreciation for each accounting period over the useful life of the asset. Depreciation is the accounting process of converting the original costs of fixed assets such as plant and machinery, equipment, etc into the expense. It refers to the decline in the value of fixed assets due to their usage, passage of time or obsolescence. Depreciation is an accounting method of allocating the cost of a tangible asset over its useful life and is used to account for declines in value over time. The Internal Revenue Service (IRS) uses the useful life of an asset to estimate the period over which depreciation of the asset may occur.
How to Determine a Tangible Asset’s Useful Life?
Salvage value is an estimate of the residual amount you will receive when you dispose of the asset. Accumulated depreciation is applicable to assets that are capitalized. Capitalized assets are assets that provide value for more than one year. Accounting rules dictate that expenses and sales are matched in the period in which they are incurred. Depreciation is a solution for this matching problem for capitalized assets.
For example, the annual depreciation on an equipment with a useful life of 20 years, a salvage value of $2000 and a cost of $100,000 is $4,900 (($100,000-$2,000)/20). The straight line basis’ simplicity is also one of its biggest drawbacks.
- Your company may purchase long-lived assets such as property, plant and equipment that you depreciate over their useful lives.
Tangible assets include fixed assets such as machinery, land, and buildings. Depreciation is the method used to allocate the cost of buildings and equipment; other types of assets use different methods of cost allocation.
Physical Values — Health, Environment
Generally, the method of depreciation to be used depends upon the patterns of expected benefits obtainable from a given asset. This means different methods would apply to different types of assets in a company. Thus, the method is based on the assumption that more amount of depreciation should be charged in early years of the asset.
Governmental Accounting Standards Board (GASB) Statement No. 51, Accounting and Financial Reporting For Intangible Assets. On the other hand, tangible assets are physical and measurable assets that are used in a company’s operations.
As an asset forays into later stages of its useful life, the cost of repairs and maintenance of such an asset increase. Hence, less amount of depreciation needs to be provided during such years. Thus, the amount of depreciation is calculated by simply dividing the difference of original cost or book value of the fixed asset and the salvage value by useful life of the asset. The useful life of an asset include the age of the asset, frequency of use, and business environmental conditions. This time period may be substantially longer than the useful life of an asset, since a functional asset may still be replaced by a more productive asset.
The equipment has an expected life of 10 years and a salvage value of $500. Fixed capital includes the assets, such as property, plant, and equipment, that are needed to start up and conduct business, even at a minimal stage. Property, plant, and equipment (PP&E) are long-term assets vital to business operations and not easily converted into cash. Purchases of PP&E are a signal that management has faith in the long-term outlook and profitability of its company.
Because this estimate is based on facts that change over time, useful life can be adjusted to compensate for such changes if they are significant and if there is a definite reason for the adjustment. The useful life of an asset is an estimation of the length of time the asset can reasonably be used to generate income and be of benefit to the company. The useful life of identical assets varies by user, and that life depends on the asset’s age, frequency of use, condition of the business environment, and repair policy. Additional factors that affect an asset’s useful life include anticipated technological improvements, changes in laws, and economic changes.
Depletion is used to allocate the cost of natural resources such as timber or coal. Amortization is used to allocate the cost of something intangible, such as a patent. Each of these methods matches the expense of an asset to the period it is being used in. Accountants like the straight line method because it is easy to use, renders fewer errors over the life of the asset, and expenses the same amount everyaccounting period. Unlike more complex methodologies, such asdouble declining balance, straight line is simple and only uses three different variables to calculate the amount of depreciation each accounting period.
How is spiritual life compared to physical life?
Physical life is the period of time that an asset remains functional. This time period may be substantially longer than the useful life of an asset, since a functional asset may still be replaced by a more productive asset. Also, the asset may become too expensive to operate profitably after a period of time.
One of the most obvious pitfalls of using this method is that the useful life calculation is based on guesswork. For example, there is always a risk that technological advancements could potentially render the asset obsolete earlier than expected. Moreover, the straight line basis does not factor in the accelerated loss of an asset’s value in the short-term, nor the likelihood that it will cost more to maintain as it gets older.
The IRS requires you to depreciate most property put into service after 1986 using the modified accelerated cost recovery system, though you can elect to exclude certain properties from MACRS. This system determines the depreciable lifetime of your property and offers its own set of depreciation methods. You need to determine a suitable way to allocate cost of the asset over the periods during which the asset is used.