Why land is not depreciated
/Why Land is not Depreciated
You might spend a substantial sum to purchase land, and then find that you are not allowed to depreciate its cost. This is a significant issue, since depreciation is a business expense that can reduce your taxable income. Here are the reasons why land is not depreciated:
Land has an unlimited useful life. Unlike buildings or equipment, land does not wear out or get used up over time. Since depreciation is based on the consumption of an asset’s useful life, land does not qualify.
Land typically appreciates in value. In many cases, land tends to increase in value due to factors like development, scarcity, or market demand. Depreciating an asset that may appreciate would conflict with the principle of conservatism in accounting.
Land does not suffer from physical deterioration. Buildings and equipment deteriorate due to usage and weather, but land does not physically deteriorate in a way that affects its capacity to serve its intended purpose. Therefore, there is no loss of value to allocate through depreciation.
Land is not subject to obsolescence. Assets like machinery can become obsolete due to technological advances, but land is not subject to obsolescence. Its utility remains intact regardless of changes in market or production methods.
Land remains usable indefinitely. Since land can be used for an unlimited time without being consumed or worn out, there is no basis to systematically allocate its cost over periods. This is unlike other assets whose service potential declines over time.
Accounting standards prohibit it. GAAP and IFRS explicitly state that land should not be depreciated. This is a formal rule in financial reporting, preventing companies from depreciating land even if they wanted to.
When an entity purchases land that has a building on it, the cost must be allocated between the land and the building; the result will be depreciation of the building, but not the land. A good way to derive this allocation is to use a property tax assessment or appraisal.
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When Land is Depleted
The one exception to the rule not to depreciate land is when some aspect of the land is actually used up, such as when a mine is emptied of its ore reserves. In this case, you depreciate the natural resources in the land using the depletion method.
Depletion is the annual charge for the use of natural resources. In order to compute depletion, it is first necessary to establish a depletion base, which is the amount of the depletable asset. The depletion base includes the following elements:
Acquisition costs—The cost to obtain the property rights through purchase or lease, or royalty payments to the property owner.
Exploration costs—Typically, these costs are expensed as incurred; however in certain circumstances in the oil and gas industry, they may be capitalized.
Development costs—Intangible development costs such as drilling costs, tunnels, shafts, and wells.
Restoration costs—The costs of restoring the property to its natural state after extraction of the natural resources has been completed.
The amount of the depletion base, less its estimated salvage value, is charged to depletion expense each period using a depletion rate per unit extracted, or unit depletion rate that is computed using the following formula:
(1 / total expected recoverable units) x depletion base x units extracted = unit depletion rate
The unit depletion rate is revised frequently due to the uncertainties surrounding the recovery of natural resources. The revision is made prospectively; the remaining undepleted cost is allocated over the remaining expected recoverable units.
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