The Concept of Asset Depreciation Part 1
Written by Farhaa Xha for Gaebler Ventures
If you are solely managing your business accounts, this article is for you! It will aid you in identifying with an important accounting concept in a simple, 'Entrepreneurial friendly' way!
What is depreciation?
SSAP defines it as a 'measure of the wearing out, consumption or other reduction in the useful economic life of a fixed asset whether arising from use, passage of time or obsolescence through technological or market changes.
In other words, depreciation is the lasting and continuing decrease in the value of a fixed asset. Examples of common Depreciated Items: furniture, van, cash register, oven, Computer, etc.
Why do assets depreciate?
Physical wear and tear: Physical usage resulting in rot, decay, rust etc. e.g. car deteriorating with mileage traveled.
Passage of time.
Physical aspects: Due to natural disasters like earthquake, flood, extreme heat or cold.
Technological obsolescence: introduction of new, possibly, availability of cost effective, more productive replacement.
Market Obsolescence: If the product which your asset is producing experiences a fall in demand or goes out of fashion.
How does it affect my Income statement?
It is expected that fixed assets over its useful years should be able to generate revenues for its business. As revenue being earned, we need to provide for depreciation cost to match these revenues. This also conforms to the matching principle of accounting which requires that the expense of assets should be 'matched' against its benefits which assets produce.
Failing to compute deprecation will result in overstating your income and thus profits. On the Income statement depreciation is written under EXPENSES: as the total amount of depreciation. Although it is recorded as a negative item in the income statement, it is a non monetary cost i.e. the amount of the annual charge for depreciation does not affect the cash flow of the business. When you purchase, say, machinery for $4000 the only outflow of cash occurs when you make payments and depreciation calculation spreads the cost of this asset over its useful life. Depreciation subtraction reduces income and hence tax paid, It improves cash flow and shelters income. It does not offer funds for asset replacement.
How does it affect my Balance Sheet?
In the balance sheet depreciation will be indicated by the BOOK VALUE of the asset i.e. original value - Accumulated Depreciation. The word 'accumulated' is important here, which means each year the provision for depreciation is increased by the depreciation charge for that year. And in the BALANCE SHEET this 'accumulated' provision for depreciation is deducted from its original purchase price of the fixed assets to arrive at the 'book value' for that particular period. For example, a machine is worth $2000 and accumulated deprecation for two year arrives at $ 400. On the balance sheet, the recorded figure would be $1600 Failing to account for depreciation in the Balance sheet would result in profits being overstated and would not reveal the true and fair value of our fixed assets .
What can and cannot be depreciated?
Most fixed assts are subject to depreciation; however, assts that will be used up within an accounting year are not. Land cannot be depreciated as it retains its usefulness for an indefinite period, it does not lose its value, wear out or have useful life that can be determined. In fact, it often increases in value. Similarly lease property is not depreciated as only the proprietor of the property claim depreciation expenses.
Intangible assets are not 'depreciated'. Intangible assets signifies value to the owner but cannot be directly touched or seen. For example, subscribers list, trademarks, patents, franchises business license. These are not depreciable instead 'amortized'. Only purchased intangible assets can be amortized.
What data do I require to calculate depreciation?
1. All costs incurred in making the asset 'usable' to the business should be included.
purchase price of the asset, (historic cost )
shipping and delivery of the asset
2. Estimated useful life
3. Residual or Salvage value: An estimation of the sales price of the asset at the end of its useful life.
Farhaa is a student pursuing a concentration in Economics and Finance at London school of Economics and Political Science, University of London. She is passionate about making accounting and economics accessible to entrepreneurs. Farhaa will also be sharing unconventional yet effective ways of recruiting.
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