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Simple English definitions for legal terms
depreciation
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A quick definition of depreciation:
Depreciation: When something gets old or used up, it loses value. This happens to things like machines, cars, and even buildings. People and businesses need to keep track of how much value is lost each year, so they can report it on their taxes and financial statements. This is called depreciation. There are different ways to calculate it, but the most common is to spread the loss evenly over the item's useful life. This helps make sure that people and businesses are paying the right amount of taxes and showing their financial health accurately.
A more thorough explanation:
Depreciation is when something loses value over time due to wear and tear. This happens to many things, like appliances and construction machinery, and they eventually need to be replaced. For businesses and individuals, large items that lose value can affect their balance sheet, income statements, and taxes. To account for this loss of value, the cost of an asset is spread out over its useful life through a process called depreciation.
When it comes to taxes, businesses and individuals must decide how to depreciate assets over time because they can take a tax deduction for the asset. The IRS has strict rules for how different types of assets must be depreciated, with some being depreciated in one year and others over many years. This is because depreciation reduces taxable income and is subject to abuse.
In accounting, businesses want their profits to appear high or low for various reasons. Large purchases of equipment can greatly affect profitability in a given year. To prevent abuse, national and international standards govern how items must be depreciated over time, such as generally accepted accounting principles (GAAP).
There are many ways to calculate depreciation, but the most common is the straight-line method. This evenly depreciates the asset over its useful life. For example, if a company purchased a generator for $10,000 with a useful life of ten years, the company would depreciate the generator $1,000 each year for ten years. Another popular method is the declining balance method, which depreciates the asset based on a percentage equal to the useful life of the asset.
For instance, a car loses much more value in its first year than its last useful year. So, if a company purchased a car for $20,000 with a useful life of five years, they could use the declining balance method to take a 40% deduction in the first year, a 24% deduction in the second year, and so on until the car is fully depreciated.