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What is Financial Depreciation?

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  • Written By: A. Leverkuhn
  • Edited By: Andrew Jones
  • Last Modified Date: 24 October 2016
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Financial depreciation is the loss in the value of assets due to their age. This most often applies to different kinds of equipment, vehicles or machinery. Financial depreciation also applies to buildings and other physical assets. Companies, businesses and other parties measure financial depreciation for several purposes. Calculating depreciation helps with internal bookkeeping. It also facilitates accounting for tax purposes, where the IRS allows for specific business deductions based on the depreciation of business assets.

In the general category of financial depreciation, different kinds of depreciation lead to different results. Experts have identified two main kinds of depreciation: physical and functional depreciation. A common definition is that physical depreciation deals with the tangible degradation of the asset, whether it’s by decaying of parts, mechanical wear and tear, or other factors. Functional depreciation would have to do with the “market age” of the asset, and how much less it would be worth in a current market. Most people refer to this idea as “obsolescence;” as newer items come onto markets, the older models get less valuable over time, even if they are still in good working order. This is a critical part of the depreciation of vehicles, electronics, and other equipment.

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There are also different ways to value depreciation, including the diminishing balance method, the fixed installment method, and the straight line method. All of these apply different financial models to the same process. Some experts consider the straight line method to measure the “salvage value” of an asset, but not all methods are as simple. Some methods, like a declining or diminishing balance, may allow greater depreciation earlier in the life of a piece of equipment by calculating depreciations differently.

Businesses often look at how to depreciate equipment strategically in order to achieve the lowest tax burden. The IRS sometimes offers to filers, several choices on how to depreciate large assets used in business. Depreciation calculators can help tax payers to see how their assets would be “assessed” in order to have a more concrete view of how much their purchases have depreciated over time. Accounting professionals will generally be familiar with the different kinds of depreciation, and able to offer accurate methods for bookkeeping within a business, and for applying the required calculations and reports for the annual tax filing.

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