The decline in the value of the assets owned by the company over time is called depreciation. It is caused by factors like usage, deterioration, and technological progress. Accountants do decrease a firm’s income when they prepare financial reports and depreciation expenses are recorded. Precise calculation of depreciation is important to avoid inaccuracies in financial statements.
We will now explore the topic of depreciation, its importance, and the factors that contribute to its level in this post.
What is Depreciation?
Depreciation, in other words, is the process of a company’s assets gradually losing their value due to various factors, such as usage, wear and tear, and obsolescence. In a nutshell, it is using the expected useful life of an asset to spread the cost of that asset over time. Depreciation is calculated on a straight-line basis from the original purchase price to the depreciable amount irrespective of the current market value. Eligible depreciation assets generally involve machines, computers, furniture, vehicles, and so on.
To qualify for depreciation:
1. Individual or company ownership is a precondition.
2. The asset should be put into operation and used in business processes.
3. The accounting period for its expected useful life should be longer than one.
4. The asset’s useful life must be capable of reasonable determination.
Features of Depreciation
1. Reduction in Fixed Asset Book Value: The decrease in the book value of a fixed asset is not the same as a decrease in its market value, which is depreciation. It is worked out as a fixed percentage of the asset’s cost price.
2. Non-Cash Expense: Depreciation is considered a non-cash expense since it doesn’t include cash outflow, rather than a technique of cutting the bookkeeping cost to match the value of the asset over its useful life. On the cash flow statement, depreciation is added to the profits in the operating activities section.
3. Ongoing Process: Depreciation is a continuous process during which the value of fixed assets goes down by a certain fraction every year. An annual charge is levied against fixed assets, which results in the depreciable amount being deducted from the asset’s book value.
4. Impact on Profit: The Depreciation is considered as an expense against profit irrespective of the company’s profitability. Even in those periods of diminishment, depreciation is accounted for because assets will eventually have to be replaced. This deduction from the operational profit is a must for the true profit calculation in the income statement.
5. Tax Advantage: Depreciation provides tax advantages to companies as they reduce profits before tax payment. This adjustment cuts taxable income thus tax payments on diminished profits will be less.
Factors Affecting Depreciation and Capital Expenditure
Depreciation and capital expenditure are the twin concepts that are responsible for the financial health of a business. Depreciation refers to the decrease in the value of an asset annually, whereas capital expenditure involves buying long-term assets for future returns. This is because depreciation affects asset valuation, and in most cases capital expenditure deals with assets subject to depreciation. In this part of the discussion, we examine what causes both and how they affect lower prices.
1. Age and State of Assets
The age and condition are very important factors in calculating depreciation rates. Assets with higher age and those in poor condition wear out faster due to increased wear and tear as well as higher maintenance costs. Routine maintenance can help in preventing such consequences.
2. Technological Advancements
Technological progress has a significant impact on asset depreciation. Outdated technologies depreciate faster, which calls for investment in technologies that will not depreciate too fast.
3. Market Demand
Highly demanded assets are depreciated slower, due to increased value, whereas low demanded assets are depreciated faster. Investing in assets with long-term demand can decrease the depreciation rates of the assets.
4. Cost of Capital
The cost of borrowing determines the values of the assets in the long run. High borrowing costs increase depreciation, so the investments should focus on assets that will be able to generate high returns to neutralize the borrowing costs.
5. Tax Regulations
The tax system impacts depreciation through the rulings of deductible amounts. Tax laws allow certain assets to depreciate quicker than others, providing tax breaks. Working together with tax experts helps to get better tax advantages and avoid tax issues caused by depreciation costs.
The knowledge of these factors helps companies to make smart decisions regarding asset management, capital expenditure, and taxes, which in the long run ensures financial stability and returns are maximized.
Why is There a Need for Depreciation?
1. For True Profit/Loss Calculation
The real profit of a business is understood only after all expenses and losses of the year are deducted from the overall revenue. The depreciation of assets is not taken into account, which misrepresents the financial snapshot as revenue remains unadjusted, and assets are overvalued.
2. For Tax Benefits
Depreciation presents tax benefits by lowering taxable income before paying tax. As a result of this adjustment, taxes owed are reduced since due to the depreciated profit, taxable income is lowered.
3. To Determine Correct Production Costs
Depreciation, just like other business expenses, matters in determining the correct production costs. Taking depreciation into account enables us to calculate the real cost of production correctly.
4. For Asset Replacement Funding
Even though depreciation is registered as an expense in the Profit and Loss Account, there is no need for actual cash outflow. Contrary to this, the deflated amount stays within the company thus being available for the purchase of future assets.
5. To Prevent Improper Profit Distribution
Ignoring to charge depreciation overstates the amount of reported profit in the Profit and Loss Account, which in turn might result in improper profit distributions to owners or shareholders. By adding depreciation to the picture, the company can be certain that the profits are distributed realistically, and capital is not depleted unnecessarily.
