Assets are an integral part of any business, and their proper management is crucial for the success of the organization. Depreciation is an accounting method used to allocate the cost of an asset over its useful life. It is a way of recognizing the wear and tear of an asset and its eventual obsolescence. However, not all assets can be depreciated, and it is important to understand what assets cannot be depreciated.
Depreciation is applicable to tangible assets like buildings, machinery, and equipment, as well as intangible assets like patents, copyrights, and trademarks. However, there are certain assets that cannot be depreciated, such as land. Land is considered to have an indefinite useful life, and its value is not expected to diminish over time. Therefore, it is not subject to depreciation. Other assets that cannot be depreciated include works of art, historical treasures, and investments in equity securities.
Understanding which assets can and cannot be depreciated is important for businesses to accurately reflect their financial position. Depreciation expenses can significantly impact a company’s net income and taxes, and misclassification of assets can result in inaccurate financial statements. Therefore, it is crucial for businesses to seek professional advice and ensure they are properly accounting for their assets.
What is Depreciation?
Definition
The boring definition: Depreciation is the process of allocating the cost of a tangible asset over its useful life.
Here’s an easier to understand definition: Depreciation is expensing a portion of an asset each year.
It is a method of accounting that recognizes the gradual decrease in value of an asset as it is used and wears out over time. Depreciation is used to spread the cost of an asset over its useful life, allowing businesses to match the expense of acquiring the asset with the revenue generated by its use.
Requirements
In order for an asset to be depreciated, it must meet certain requirements. The asset must be tangible, meaning it can be seen and touched, and it must have a determinable useful life. This means that the asset must have a limited lifespan, and its useful life must be able to be estimated with reasonable accuracy. Additionally, the asset must have an intrinsic value, meaning that it has value in and of itself, and not just because of its ability to generate revenue.
Non-depreciable assets, on the other hand, are assets that do not lose value over time and therefore cannot be depreciated. These may include intangible assets such as patents, trademarks, and copyrights, as well as land and certain types of investments.
Types of Assets
Tangible Assets
Tangible assets are physical assets that can be touched, seen, and felt. These assets have a finite useful life and can be depreciated over time. Examples of tangible assets include buildings, vehicles, land, property, equipment, machinery, furniture, and computers.
Intangible Assets
Intangible assets are assets that are not physical in nature and cannot be touched, seen, or felt. These assets are non-physical in nature and can be difficult to value. Examples of intangible assets include patents, copyrights, and trademarks.
Non-Depreciable Assets
Non-depreciable assets are assets that cannot be depreciated because they have an infinite useful life. These assets are not subject to wear and tear and do not lose their value over time. Examples of non-depreciable assets include collectibles, inventory, receivables, and current assets.
Depreciation Methods
Straight-Line Method
The straight-line method is the simplest method of depreciation. Under this method, the cost of the asset is spread out evenly over its useful life. The formula for calculating depreciation using the straight-line method is:
Depreciation expense = (Cost of asset – Salvage value) / Useful life
The salvage value is the estimated value of the asset at the end of its useful life. The useful life is the estimated number of years that the asset will be used.
Declining Balance Method
The declining balance method is an accelerated depreciation method. Under this method, a fixed percentage of the asset’s book value is depreciated each year. The formula for calculating depreciation using the declining balance method is:
Depreciation expense = Book value of asset x Depreciation rate
The depreciation rate is a percentage that is determined by dividing 1 by the useful life of the asset. The book value of the asset is the cost of the asset minus the accumulated depreciation.
Units of Production Method
The units of production method is used to depreciate assets that are used to produce goods or services. Under this method, the cost of the asset is spread out over the number of units that are produced. The formula for calculating depreciation using the units of production method is:
Depreciation expense = (Cost of asset – Salvage value) / Estimated total units of production x Actual units of production
Sum-of-the-Years-Digits Method
Under this method, the depreciation expense is highest in the first year and decreases each year thereafter. The formula for calculating depreciation using the sum-of-the-years-digits method is:
Depreciation expense = (Cost of asset – Salvage value) x (Remaining useful life / Sum of the years digits)
The sum of the years digits is calculated by adding together the digits of the useful life of the asset. For example, if the useful life of the asset is 5 years, the sum of the years digits would be 15 (1 + 2 + 3 + 4 + 5).
What Asset Cannot Be Depreciated?
Cash, Stocks, and Bonds
Cash, stocks, and bonds are financial assets that do not have a physical life. As such, they cannot be depreciated.
Personal Property for Personal Use
Personal property such as clothing, furniture, and electronics that are used for personal purposes cannot be depreciated. However, if the same items are used for business purposes, they may be eligible for depreciation.
Business Expenses
Expenses such as advertising, salaries, and rent cannot be depreciated because they are not considered assets. They are considered as expenses that reduce taxable income.
Leased Property
Leased property cannot be depreciated by the lessee. Only the lessor can depreciate the property.
Natural Resources
Natural resources such as oil, gas, and minerals cannot be depreciated. Instead, they are subject to depletion, which is the reduction in the quantity of the resource due to extraction or consumption.
Trademarks
This is really just semantics but trademarks and other intangible assets such as patents and copyrights cannot be depreciated. Instead, they are subject to amortization, which is the process of allocating the cost of the asset over its useful life.
Owned by You or Your Business
Assets that are owned by you or your business but are not used for business purposes cannot be depreciated. For example, a personal residence cannot be depreciated.
Commercial Property for Investment Purposes
Commercial property that is held for investment purposes cannot be depreciated. However, if the property is used in a business, it may be eligible for depreciation.
In conclusion, not all assets can be depreciated. It is important to understand which assets can and cannot be depreciated to accurately calculate the depreciation expense for tax purposes.