Depreciation is the accounting of the deterioration of the physical and functional utility of a fixed asset due to usage and time.  Depreciation can be explained in economic or accounting terms.  While economic depreciation is useful in understanding the concept of depreciation, we will be focusing primarily on accounting depreciation.  Our objective for studying accounting depreciation is to learn how to amortize the cost of fixed assets.  Accounting depreciation is a way of writing off the investment on fixed assets by prorating over a certain period.

The accounting depreciation methods we will study are of two types: book and tax depreciation.  Book depreciation is done for the use of the company to report its financial status to its stockholders and other related people.  Tax depreciation is done for the purpose of calculating taxes.  Both methods are based on the principle of matching concept, which requires that a fraction of the cost of the asset in an accounting period, commensurate with its use in that period, is charged as an expense.

According to U.S. tax laws only fixed assets that are used in the production of income are allowed to be depreciated.  Additional requirements are that the asset will have to have at least 1 year of useful life, and it must be something that deteriorates due to use or the passage of time.  Inventories are not depreciable properties.  Land and costs associated with the clearing, grading, planting, and landscaping of land are also not depreciable.  Incidental expenses such as freight, site preparation, and installation associated with the setting up of the asset, however, are depreciable expenses.  The sum of the initial cost and the incidental costs is known as the cost basis used in the depreciation analysis.

Depreciable life of the asset is another important variable in depreciation analysis.  Since it is difficult to estimate the useful life of the asset and even more difficult to make all parties agree on the estimated life, the Internal Revenue Service has specified the lives for various categories of assets.    These lives are known as Asset Depreciation Ranges (ADR), an example of which is shown in Table 10.1 of the text.