Depreciation vs depletion definitions, meanings, differences

difference between depreciation and depletion

In order to secure the tax deduction, a company must follow the IRS rules while depreciating their assets. The IRS has fixed rules on how and when a company can claim such deductions. What might cause a decrease in the estimated life of depreciable assets? Describe how the cost principle applies to plant assets and explain the concept of depreciation. Depreciation has a wide scope as it applies across industries – namely to any entity that employs fixed assets. Depreciation is charged on any fixed tangible asset such as plant and machinery, furniture and fittings, office equipment, computers etc.

  • The unit depletion rate of a natural resource equals the cost of the asset, net of residual value, divided by the estimated number of units of the resource.
  • Each of these methods matches the expense of an asset to the period it is being used in.
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  • The planned, gradual reduction in the recorded value of a tangible asset over its useful life is referred to as depreciation.
  • Sum-of-the-years’-digits uses the depreciable base of an asset to determine the appropriate amount of depreciation expense in any period.
  • An increase in an asset or an expense is entered in the debit column; a decrease in an asset is entered in the credit column.

The allocation of sum or cost is done periodically. Even with intangible goods, you wouldn’t want to expense the cost a patent the very first year since it offers benefit to the business for years to come. Thats why the costs of gaining assets throughout the years are significant because the company can continue to use it or create revenue from it. The cost of the long-term, tangible assets can be deducted as business expenditures , which in turn reduces the taxable income. Depreciable property is otherwise known as a depreciable asset, this is an asset that can be depreciated following the Internal Revenue Service rules. When depreciated, the value of the asset is regarded as business expenses over its useful life, this is deducted from the tax return of the business. The calculation of estimated life in case of depreciable assets is simpler and is based on several documents such as production engineer’s certification, manufacturers’ certification, internal assessments etc.

How to Calculate Units of Activity or Units of Production Depreciation

The other meaning of amortization is the reduction of the cost of an intangible asset over time. Depletion is the form of depreciation that refers to natural resource assets such as mines, gravel pits, oil wells and the such. Accumulate amortization in both accounting and tax might have the same sum of have different sums. This is based on certain factors such as when depreciations are yet to be deducted from tax expense. Accumulated Depreciation is the entire portion of the cost of an asset allocated to depreciation expense since the time an asset is put into service. Depreciation is a measured conversion of the cost of an asset into an operational expense.

For financial reporting, depletion is normally charged on the basis of an activity method. A company may use composite depreciation with heterogeneous assets that have somewhat similar characteristics or purposes. It applies composite depreciation in the same way as group depreciation. Both group and composite depreciation simplify a company’s recordkeeping, particularly for large numbers of low-cost items. However, the methods may mask faulty estimates and defer gains and losses beyond the period of occurrence. Service life is a measure of the number of units of service expected from an asset before its disposal. A company may make this measurement in units of time or units of activity or output.

Difference Between Agar Well and Disc Diffusion Method

Because Company A and B have the same sales and other expenses, the only difference in their net income would be from the depreciation expense on this asset. Because Company B is using an accelerated method (double-declining balance), their expenses would be higher in 2011, which results in lower net income. Choice is incorrect because Company A is using the straight-line method, which gives a constant depreciation expense over the life of an asset. A more appropriate choice for an asset whose benefits are expected to decline over time would be one of the accelerated methods. Choice is incorrect because while their sales and other expenses are the same, the depreciation expense for B is larger than A so they could not have the same net income. Choice is incorrect because double-declining balance is a time-based depreciation method, not an activity method.

difference between depreciation and depletion

Describe the cost recovery method used for each of the four asset types . Prorating cost of an “Intangible Asset” over the period during which benefits of this asset are estimated to last is called Amortization. The concept of amortization is also used with leases & debt repayment. Depletion has limited scope as it is applicable only to entities engaged in the mining of natural resources.

Financial Accounting

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Hence cost is allocated periodically as value lost due to usage (as expense affecting the business’s net income) and the declining value of assets is recorded . Different methods exist in calculating the depreciation amount and these are different depending on the asset type.

How to Calculate Marginal Efficiency of Capital

The use of different depreciation methods for income tax reporting and financial reporting is acceptable and common. A company using group depreciation capitalizes the cost of a group of homogeneous assets in a single asset account and depreciates the cost as a single asset. The company bases the group depreciation rate on the difference between depreciation and depletion average life of the group assets and applies the rate each period to the balance in the group account. It accumulates depreciation in a single contra-asset account. It does not record a gain or loss on the assets until all assets in the group have been retired. Then the company recognizes a total net gain or loss on the group.

difference between depreciation and depletion

Service life is determined by both physical causes (wear and tear, etc.) and functional causes . An asset may still be physically functional but be obsolete and therefore be at the end of its service life.

Depreciation, Depletion, and Amortization – Explained

The discount rate used is the rate of return that the company requires for similar investments with similar risks. The company includes the impairment loss in income from continuing operations on the income statement and reports the new lower book value on the company’s ending balance sheet. As a general principle, cost allocation methods must be “systematic and rational.” To be systematic, a method must be determined by a formula and must not be arbitrary. To be rational, a method must relate each period’s depreciation expense to the benefits generated in that period. Corporations own long term assets including tangible assets like buildings, intangible like copyrights, and natural resources like ore deposits. As it comes to value these assets there should be a way to devalue. The modified accelerated cost recovery system is the onlycurrently-approved depreciation model allowed for tax depreciation in the United States.

  • Over an asset’s total life, the sum of total depreciation and gain or loss on disposal will be equal under tax and financial reporting.
  • This requires incurrence of costs such as cost of acquiring rights in the resource, cost of preparing the resource for extraction etc.
  • This results after subtracting the salvage value from the initial purchase price.
  • Such treatments of the residual value are acceptable unless the effects are material.
  • For example, if your asset depreciated by $425 during the current quarter, enter $425 in the debit column for depreciation expense and $425 in the credit column for accumulated depreciation.
  • Which of the following is not a characteristic of MACRS?
  • Which of the following statements regarding impaired assets is true?