Depreciation is a fundamental concept of accountancy. The paper explores the importance of depreciation to me (an accountancy student) and how it could be explained to a new employee in finance department. The various limitations those are inherent in the concept and the possible means of learning more about it.
Explaining the concept to a new employee
“Depreciation is the allocation of an asset’s cost over its useful life”. (Randall, 2005)
Businesses buy fixed asset which are used in the business for a number of years. These assets loose value with time. This is called Depreciation.
For example, a machine bought for $20,000 is only worth $15,000 after a year’s use, this reduction in value of $5,000 is our depreciation. This reduction in value is treated as an expense and is charged to the year’s profit and loss account. The cost of asset is also reduced by this amount in the balance sheet and arrived to an amount called Net Realizable Value (NRV).
Reasons for Depreciation:
As assets are used they wear out and suffer a loss in their original value.
Technological change is another factor for depreciation. As advancements are made in technology, equipments become outdated and will have to be sold for a meager amount.
Changes in fashion can eliminate the demand for a product and subsequently the fixed asset used to make that product.
Natural resources deplete as they are extracted from ground. (Lynch, 2006)
Methods of calculating depreciation:
Straight Line Method
This is the easiest method of calculating depreciation. This method evenly spreads the depreciation charge over the life of an asset. To calculate this we need three strings of information. Cost of asset, Disposal value (estimated value at the end of assets life) and estimated life of the asset. The formula which would then be used for calculation is.
Annual depreciation charge = Reducing Balance Method
This method of depreciation involves applying a fixed percentage to the Net book value of the Asset. Net book value is computed by deducting accumulated depreciation from the cost of the asset. The effect of this method is that the charge of depreciation is higher in the first year, and shrinks in subsequent years as the Net book value diminishes.
For e.g. lets suppose an asset was bought for $10,000 and depreciation charge is 10%. Depreciation for the year 1 would be 10,000 * 10% = $1,000.
Net book value after 1st year is 10000 – 1000 = $9000
Depreciation for year 2 would be 9000 * 10% = $900
It could be clearly seen that depreciation has declined from year 1 $1000 to year 2 by $900.
Importance of Depreciation
Concept of depreciation is important to me as an accountancy student because this concept is an application of basic accounting principles namely the matching concept. It states that expenses should be matched with the revenues of the same period. The value of fixed assets declines with time, this decline in value is an expense and so is charged against the revenue it assisted in earning.
Depreciation is an application of prudence concept as well. The value of asset diminishes with time; financial statements should reflect this and state the asset at a value they could be expected to fetch if put to sale (Net Realizable Value) in contrast to what they were purchased for. This would give stakeholders a fair view of the business and assist them in making an informed decision about future dealing with the company.
The purpose of depreciation is to provide users with accurate and realistic information about the business, same is the purpose of every accountant and so this concept has a duty of care as it can be manipulated (see below).
Limitation and concerns
A few concerns I have about this concept is that depreciation is an estimate and can be easily manipulated. In manufacturing businesses where fixed asset have significant amount a slight variation in depreciation method can reduce depreciation expense and thus could result in an artificially inflated profit. This might mislead the prospective investors into thinking that the firm is performing well, when in reality they aren’t. This is called window dressing (Hall, Jones and Raffo, 2000)
Motivation for window dressing
To make the business look healthier than it is so as to attract outside investments, gain on stock exchange by increased share prices.
Charging high depreciation in accounts that artificially reduces the profit in order to save on government taxes.
Learning more about depreciation
Internet is a good source of information. But as everyone can write on internet without proper expertise I prefer reading online journals which are accurate and authentic. University teachers should be in the priority list as they conduct research, moreover, teaching in itself is twice learning.
The concept of depreciation is a symbol of many accounting conventions. Scope of which is to prepare financial statements that are accurate, factual and dependable. This concept involves responsibility accounting as manipulation can seriously affect the decision making of stakeholders. It is important that we keep ourselves updated on accounting concepts via internet, books and teachers.
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Hall, Dave. Jones, Rob. Raffo, Carlo (2000). Business Studies. 2nd Edition Causeway press ltd
Lynch, foulks (2006) Prepearing Financial Statements 1st Edition Financial Trading Company.
Randall, Harold (2005) As and A level Accounting . 1st Edition. Cambridge University Press.
Title: Discuss the importance of depreciation expenses.
The concept and practice of depreciation plays an integral part in a company s cash flow situation and funding. The two main reasons this occurs are that firstly depreciation is a for of self finance, and secondly because a company does not have to pay taxes on depreciation, hence excluding taxation from a cash amount which enlarges the cash flow of a company.
As a term, depreciation is defined as a loss in value, a diminishment in market price, always taking the time factor into account, because the view point of depreciation is always a rate of change in value in an asset (fixed or current) compared to the present value of that asset.
If a company purchases or rents machinery, or any sort of equipment used for production purposes, it has to take into account the purchased or rented good s production life span, meaning that everything has a certain period of time in which it contributes to production before it is rendered useless. I use the term useless in the sense that what is produced does not bring profit to the company due to wear and tear resulting in production time loss and a lower standard of quality. The time based usefulness of an asset of course varies depending on what the asset is. If it is a van for example, its usefulness might be seven years before the van needs replacing, but if it is a building we are talking about, its usefulness may be forty years.
For example, is a JCB digger were to be purchased in 2000 at the value of 15000, and its productive life span were to be eight years, this would mean that in eight years time, the digger purchased would cease to be of any productive use to the company which purchased it. If it were to be resoled in 2008 though, its value would have depreciated drastically due to the time lapse from the initial purchase. Its depreciation, hence its devaluation, is its year zero value less an annual percentage of the devaluation process updated annually.
Depreciation does not only apply to current assets, but also is applicable to fixed asset as well. Buildings for example lose their value too taking the time scale factor into account. If a building is purchased in 1970 as a newly built structure, its value will have definitely decreased in 2025 by the depreciation rate estimated.
The way depreciation is worked out is by subtracting the rate of depreciation (of the year in question) from the present value. The rate of depreciation varies from year to year by its power (in the process of the annual 1 multiplied by the percentage rate of depreciation) being the year number of its depreciation and its depreciation rate possibly varying from year to year.
Because depreciation is subtracted from the assets of a financial statement, it is not subject to taxation, therefore the company has automatically achieved a higher cash flow status by depreciating its assets, the worth of its capital value. We can see this in the following mock cash flow calculation (Last Page).
In the first and second row, because depreciation is included, the cash and accounting sum of depreciation is not taxed, this leaves the company with more cash flow compared to the third column of the calculation sheet where depreciation is not included.
This form of saving, or investing, not only allows a company to have a greater financial mobility in the market it is involved in, but also ensures the replacement of necessary current and fixed assets needed for production purposes.
The best way for a firm to be financed it through self finance, and since depreciation is retained cash for future asset replacement, it is a form of self financing. This saves the company paying out interest rates on bank loans for example, an external source of finance which demands a price for the service provided to the company.
Cash Flow Calculation
Depreciation: Depreciation: No
Accounting Basis Cash Basis Depreciation
Sales 2400 2400 2400
- Cost of goods sold 1600 1600 1600
800 800 800
- Cash fixed expenses 300 300 300
500 500 500
- Depreciation 200 200 0
300 300 500
- Federal Income Taxes (40%) 120 120 200
Earnings 180 380 300
+ Depreciation 200 0 0
Cash Flow 380 380 300
Guide to working capital management, Keith V. Smith, McGraw-Hill Book Company, 1977, p.7, Exhibit 1-4
Guide to working capital management, Keith V. Smith, McGraw-Hill Book Company, 1977
Internet Search On Depreciation