What is Depreciation?

Whether or not you are aware of it, depreciation is a financial concept that affects each and every one of us. Our money, our clothes, tech items, and more, this matter of value touches everything and everyone. So, what exactly is it and how does it have an affect in such a broad way? Here are some quick answers to help you understand this important money matter.

Type 1

There are actually two different types of depreciation. The first kind though is the one that affects the most of us. In explaining it, let’s start by highlighting the fact that everything on this Earth has an associated value or worth.

When you look at all of your possessions, you are likely already familiar with the fact that each item has a specific value. The value, or worth of each item is therefore dictated by a great number of factors. How valuable is the material it is composed of? How common or rare is the item? Is it made by a quality producer or one that is known for making low-end products? Additionally, what is the item’s condition and age, and how do these factors affect the particular item?

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The first type of depreciation is therefore that of the loss of value in the broader sense of individual goods’ worth. If your item is older and thus less useful or desirable than a similar, more recent product, it is depreciating, or losing its value because of age. If you owned an expensive watch but now it has visible signs of condition loss, or wear and tear, the value of the watch will depreciate because of its less than perfect condition. The moment you purchase a new car and drive it home, it has depreciated greatly because it is no longer a new item and is now considered a “used”, less valuable commodity.

Type 2

The aforementioned type of goods-depreciating inevitably affects us all. The second function of this financial term refers strictly to a business concept involving equipment and property. Let’s start explaining this one by way of the IRS official definition of the business term. According to the IRS, this business concept is actually “an income tax deduction that allows a taxpayer to recover the cost or other basis of certain property. It is an annual allowance for the wear and tear, deterioration, or obsolescence of the property.”

To illustrate this concept, let’s take a look to a hypothetical business for example. Martin’s Taxi Service employs a fleet of 20 taxi cabs throughout the course of the year. These cabs indeed make the business money, but their value depreciates steadily due to mileage, wear and tear, and age.

Allowing tax consideration for the ever-depreciating value of the taxi company’s money-making fleet of vehicles, the IRS thus provides a method to report and factor-in this constant lowering of value of the company’s equipment. This is only fair as the company should no longer be taxed based on owning brand new, highly valuable assets. Their assets have gradually become aged and less valuable, thus the IRS rightly reflects this at tax time.

Everything on Earth has a value. When the value goes up, it is appreciating. When the value of an asset goes down, its value has depreciated. In business and at home in our own personal lives, these two concepts in depreciation affect us all.