In accounting, depreciation is a loss of value of a business asset/equipment over time. It is treated as an expense when computing profit and loss for an organization. The value of any equipment in an organization reduces over time due to continuous use. Since depreciation is equally important like other expenses, the management of a firm needs to come up with appropriate accounting policies and proper depreciation methods that will see the firm manage its equipment well to avoid unnecessary shortages or excess equipment in the organization (Harrison & Horngren, 2008). Precise financial results are realized when a firm understands the significance of depreciation while preparing the financial statements of an organization.
The concept of Depreciation and its importance
Capital equipment or an asset used up in the production of goods cannot maintain the original status or value. Even when the machine is not in use, it has to undergo depreciation that may be caused by wear and tear or obsolescence (Kieso, Weygandt & Warfield, 2007). Depreciation represents a cost to the firm. It is advisable that the assets be replaced once their useful life is over to get the firm back to its production activities. Depreciation is a non-cash expense that should be accounted for more appropriately to reflect the true picture of an organization. A quite number of accounting methods are being relied on in writing off the asset’s depreciation cost over a particular period (Harrison & Horngren, 2008). Some of the famous accounting methods used to write off the assets are declining balance method and straight-line methods. Under the straight-line method, the assets depreciate uniformly and they can have their book value equaling to zero. However, under the declining method, an asset depreciates faster during the initial first years and the asset cannot depreciate up to zero value.
The cost allocation is always based on several factors. It is also related to the anticipated time that the asset is capable of generating income for the organization. Depreciation expense is the total amount of allocation cost in a given accounting period. Only assets that are likely to lose value over time are depreciated and that is the reason why land is not depreciable (Kieso, Weygandt & Warfield, 2007).
The significance of Depreciation accounting in the management of a firm’s Investment Costs and Taxes
For better management of a company’s assets, the management needs to be conversant with all the depreciation aspects and concepts. This is because of the significance of depreciation to the production assets of an organization. The assets’ true value can only be determined after allocating their associated depreciation costs and charging them to the relevant cost structures (Harrison & Horngren, 2008). Different accounting policies for depreciation are used by different organizations. This is because every enterprise has its unique accounting policies that it relies on while accounting for depreciation. Depreciation has a significant impact on the determination and presentation of the financial position and results of a company. The depreciation amount to be charged in a given accounting period is based on three factors: the anticipated useful life of the asset, the estimated residual value of the asset and the asset’s historical cost (Kieso, Weygandt & Warfield, 2007). The historical cost of an asset or equipment is the actual cost of the asset that was incurred during its acquisition. However, the historical cost may undergo unexpected changes due to an increase or decrease in the organization’s long-term liability. Usually, the asset’s useful life is shorter than its physical life. The useful life is also determined by the nature of use and physical deterioration. Useful life of an asset is determined through estimation and certain external factors such as experience with regard to similar types of assets. The management faces some problems while determining some assets’ residual value. In situations where such value is considered insignificant, its value is nil. However, if the residual value of the asset is likely to be significant, it is estimated at the acquisition time (Harrison & Horngren, 2008).
The depreciation quantum to be considered in a given accounting period entails the judgment exercised by the relevant authority taking into consideration technical, economical and other legal requirements. The company’s management is vested with the overall responsibility of selecting the most suitable method of depreciating assets taking into consideration important factors such as the nature and type of an asset, the nature of use of such equipment, and the circumstances surrounding the business (Kieso, Weygandt & Warfield, 2007). A company may opt to use more than one depreciation method on its assets. If some depreciable equipment is lacking material value, depreciation is usually charged to the accounting period in which it was purchased.
Depreciation accounting is an important component that helps firms to make vital investment decisions, the organization’s future performance and prosperity and is dependent upon the investment decisions arrived at by the organization’s management. In most cases, they entail the investment in capital equipment that is prone to depreciation. Therefore, better estimation and allocation of depreciation is very crucial to determine when a given asset is likely to be used within the firm (Harrison & Horngren, 2008). Once the management has established the rate to be applied as well as the depreciation method, it becomes easy to determine when such assets are going to last in an organization and subsequently predict the exact time when the assets need replacement. The investment costs are appropriately managed after determining the true value of the assets and equipment within the organization.
When it comes to taxation, the asset’s adjusted tax value is computed to determine the exact value of all assets at hand that needs to be taxed. The taxable value of an asset is arrived at by subtracting all depreciations that have accumulated since the asset was acquired from the cost price of the asset (Kieso, Weygandt & Warfield, 2007). The management needs to have excellent policies since the higher the book value the, the higher the tax to be paid and vice versa. If the depreciation is designed in such a way as to have high book value or residual value for assets whose contribution to the organization’s earnings has been minimal, then the organization is likely to part with higher unnecessary taxation costs and it is a huge loss to the company. Sometimes a company may be in possession of assets that the company no longer uses. In such instances, the management ought to be keen not to allow the taxing authorizes impose tax on the assets. That is to say, taxable assets must be separated from non-taxable assets. Full disclosure of all the information concerning organization’s assets is important to allow some level of accuracy to prevail while carrying out taxation (Harrison & Horngren, 2008). The management of an organization needs to be well informed of the total assets in the organization and the tax rate applied to each of them. This is because assets tend to have different applicable rates of depreciation.
Depreciation is very important in determining the organization’s final earnings. The management of an organization relies on depreciation to make the organization’s long-term investment decisions. Failure to calculate the depreciation figures correctly may end up giving incorrect financial results. However, the method to be used in allocating depreciation costs varies from organization to organization depending on the organization’s policies. It should be also noted that there are common accounting concepts and policies that must be complied with in allocating the depreciation costs to the assets (Harrison & Horngren, 2008). The tax payable by a company depends on the book value of the assets that will be taxed. Depreciation is an expense just like other expenses and is a cost to the organization. It is advisable to treat depreciation with utmost care to create a relatively precise financial picture of the organization.
Harrison, W.T. & Horngren, C.T. (2008). Financial Accounting. 7 Ed. New York, NY: Prentice Hall.
Kieso, D.E., Weygandt, J.J. & Warfield, T. D. (2007). Intermediate Accounting. New York, NY: Wiley Publishers.