Capital items and depreciation

Almost every business must invest in some major equipment, vehicles, machinery, or furniture in order to operate. Some businesses will require assets such as land, a building, patents, or franchise rights. Major assets that will be used in your business for more than a year are known as "capital assets" and are subject to special treatment under the tax laws. Most importantly, you generally can't deduct the entire cost of acquiring such an asset in the year you acquire it.
Why not? Because one of the goals of accounting is to accurately measure a business's gross income, expenses, and net income (earnings) during a given period of time, usually a year. If a business were allowed to reduce one year's gross income by an expense deduction for the total cost of an item that will be used for several years, the result would be an understatement of earnings in the year the asset was purchased, and an overstatement of earnings during the following years.
It follows that, for "capital assets" (assets that have a useful life of more than one year), the cost must be written off (that is, depreciated or amortized) over more than one year.
Theoretically, the cost of an asset should be deducted over the number of years that the asset will be used, according to the actual drop in value that the asset will suffer each year. At the end of each year, you could subtract all depreciation claimed to date from the cost of the asset, to arrive at the asset's "book value," which would be equal to its market value. At the end of the asset's useful life for the business, any undepreciated portion would represent the salvage value for which the asset could be sold or scrapped.
Since the actual drop in value of each business asset would be difficult and time-consuming to compute (if indeed it could be computed at all), accountants use a variety of conventions to approximate and standardize the depreciation process.
For example, the straight-line method assumes that the asset depreciates by an equal percentage of its original value for each year that it's used. In contrast, the declining balance method assumes that the asset depreciates more in the earlier years. The following table compares the depreciation amounts that would be available under these two methods, for a $1,000 asset that's expected to be used for five years and then sold for $100 in scrap.

	Straight-Line Method		Declining-Balance Method
Year	Annual Depreciation	Year-End Book Value	Annual Depreciation	Year-End Book Value
1	$900 x 20%=$180	$1,000-$180=$820	$1,000 x 40%=$400	$1,000-$400=$600
2	$900 x 20%=$180	$820-$180=$640	$600 x 40%=$240	$600-$240=$360
3	$900 x 20%=$180	$640-$180=$460	$360 x 40%=$144	$360-144=$216
4	$900 x 20%=$180	$460-$180=$280	$216 x 40%=$86.40	$216-$86.40=$129.60
5	$900 x 20%=$180	$280-$180=$100	$129.60 x 40%=$51.84	$129.60-$51.84=$77.76

As you can see, the straight-line method results in the same deduction amount every year, while the declining-balance method results in larger deductions in the first years and much smaller deductions in the last two years. One implication of this system is that if the equipment is expected to be sold for a higher value at some point in the middle of its life, the declining balance method can result in a greater taxable gain that year because the book value of the asset will be relatively lower.

Capital Investment/Depreciation/R&D Expenditure

(Millions of yen)

No.	Item	The year ended March 31, 2005	The year ended March 31, 2006	The year ended March 31, 2007	The year ended March 31, 2008	The year ended March 31, 2009
1	Capital investment*	959,593	954,706	1,048,572	969,087	788,466
	Internal use assets	382,189	397,419	522,974	512,428	424,064
	Leasing assets	577,404	557,287	525,598	456,659	364,402
2	Depreciation	425,080	451,170	472,175	541,470	478,759
	Internal use assets	313,884	329,684	346,431	417,270	392,234
	Leasing assets	111,196	121,486	125,744	124,200	86,525
3	R&D expenditure	388,634	405,079	412,534	428,171	416,517
	Percentage of revenues	4.3%	4.3%	4.0%	3.8%	4.2%

• * Capital investment is completion basis, including leasing assets.

Number of Employees/Number of Consolidated Subsidiaries

No.	Item	As of March 31, 2005	As of March 31, 2006	As of March 31, 2007	As of March 31, 2008	As of March 31, 2009
1	Number of employees	347,424	355,879	384,444	389,752	400,129
	Japan	242,891	242,659	250,767	251,702	260,677
	Outside Japan	104,533	113,220	133,677	138,050	139,452
2	Number of consolidated subsidiaries*	985	932	934	910	943
	Japan	539	476	450	418	403
	Outside Japan	446	456	484	492	540

• * Including variable interest entities

Methods of depreciation

There are several methods for calculating depreciation, generally based on either the passage of time or the level of activity (or use) of the asset.

[edit] Straight-line depreciation

Straight-line depreciation is the simplest and most-often-used technique, in which the company estimates the salvage value of the asset at the end of the period during which it will be used to generate revenues (useful life) and will expense a portion of original cost in equal increments over that period. The salvage value is an estimate of the value of the asset at the time it will be sold or disposed of; it may be zero or even negative. Salvage value is also known as scrap value or residual value.
Straight-Line Method:

For example, a vehicle that depreciates over 5 years, is purchased at a cost of US$17,000, and will have a salvage value of US$2000, will depreciate at US$3,000 per year: ($17,000 - $2,000)/ 5 years = $3,000 annual straight-line depreciation expense. In other words, it is the depreciable cost of the asset divided by the number of years of its useful life.
This table illustrates the straight-line method of depreciation. Book value at the beginning of the first year of depreciation is the original cost of the asset. At any time book value equals original cost minus accumulated depreciation.
Book Value = Original Cost - Accumulated Depreciation Book value at the end of year becomes book value at the beginning of next year. The asset is depreciated until the book value equals scrap value.

Book Value - Beginning of Year	Depreciation Expense	Accumulated Depreciation	Book Value - End of Year
$17,000 (Original Cost)	$3,000	$3,000	$14,000
$14,000	$3,000	$6,000	$11,000
$11,000	$3,000	$9,000	$8,000
$8,000	$3,000	$12,000	$5,000
$5,000	$3,000	$15,000	$2,000 (Scrap Value)

If the vehicle were to be sold and the sales price exceeded the depreciated value (net book value) then the excess would be considered a gain and subject to depreciation recapture. In addition, this gain above the depreciated value would be recognized as ordinary income by the tax office. If the sales price is ever less than the book value, the resulting capital loss is tax deductible. If the sale price were ever more than the original book value, then the gain above the original book value is recognized as a capital gain.
If a company chooses to depreciate an asset at a different rate from that used by the tax office then this generates a timing difference in the income statement due to the difference (at a point in time) between the taxation department's and company's view of the profit.