Effective Life and Depreciation of an Asset

Large Earth Moving Heavy EquipmentWhat is the value of an asset?

An asset doesn’t maintain the value of its original purchase price. If you have ever sold a car second-hand you will be painfully aware of this fact. Depending on the type of asset it is, in may appreciate in value (for example an investment property) or, more commonly for businesses, depreciate in value (equipment used in the business that will wear out at some point in the future).

The ATO has a depreciation schedule for many assets, which is called the ‘determinations of effective life’, which is published annually in the ATO’s Taxation Rulings. The effective life of an asset may vary from a few years (for things like software) to decades for more durable assets such as patents, copyrights or things like the expected life of a mine.

There are several other factors taken into account. These include:

  • Is the asset subject to wear and tear?
  • Is it being maintained in reasonably good condition?
  • What is the amount of time before it is likely to be scrapped or sold for scrap?

Once you know how long the asset is likely to last you can work out the depreciation schedule of that asset.

The ATO offers two types of depreciation schedule:

Straight line or prime cost method, which involves dividing the asset’s cost by the number of years it will last. This is a very simple calculation that results in an even amount of depreciation for the asset every year of its life.

Diminishing value method. This method is slightly more complex, in that you are calculating the depreciation as a percentage from the previous year’s value rather than the original cost. The result of using this schedule is that the amount of depreciation will be significantly higher in the early years, then steadily reduce in each ensuing year.

The benefit of the diminishing value method is that it allows a business to claim more depreciation expense earlier in the life of the asset, thereby reducing the taxable income for the business in those years. The flip side of course is that the diminishing value method results in less depreciation in the later years of the assets life than the straight line method. However, because depreciation is a paper expense only, meaning the depreciation expense isn’t actually an expense that you have to pay to a creditor, it is ideal for businesses (especially start-ups) that are trying to reduce their tax debt early on when they may have limited cash flow and high set-up costs.

By Jennifer Lowe

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