Definition & Purpose of Depreciation

Every organization possesses fixed assets such as land, a building or plant, machinery and equipment. Over a period of time, the value of some assets goes up and the value of some declines. When the value rises, the asset has appreciated and when the value diminishes, the asset has depreciated.

Eventually the net worth of equipment, plant and machinery deteriorates owing to wear and tear, obsolescence and getting outdated. Virtually all organizations need, each year, to provide for depreciating assets. This concept is very useful from an accounting and taxation point of view.

Function

The rationale behind depreciating assets is to derive that value for them that they would command in the market if sold in the present day. Assessing equipment in this manner offsets losses in the real scenario of sale.

For example, consider a circumstance when the organization has purchased a computer today for $1,200 and estimates that it can be expected to be effectively used for five years. Perhaps guesstimating its scrap value would be $200, they would spread that $1,000 expense over the five years, so as to not incur all the loss at the end of the device's useful service.

Significance

Depreciation is significantly important in showing the current value of the asset and not its book value. This way the company's financial statements reflect a true and correct picture of the value of the assets and liabilities. Availability of newer and improved products along with wear and tear on what's in place attribute to the value of assets diminishing .By instituting this practice, the company does not incur losses when the asset stops working and has to be sold off.

Benefits

Provision made against depreciation is tax-exempt. Money saved is money earned for the company and its stakeholders. Hence the company is able to logically distribute the money saved as profits/dividends, or to retain or reinvest the money in the business for expansion and development purposes.

Time Frame

Assets are depreciated once a year. This exercise is carried out at the time of preparation of the firm's financial statements.

Types

There are several ways to handle depreciating assets. The premise of each of the methods is the same--spreading the reduction in value over the functional and useful life of the asset. Approaches commonly in practice include the straight-line, the double-declining, the reducing balance and the sum-of-years methods. In the first method, the asset is depreciated by a constant value each year. In the other three methods, the value of the asset declines more rapidly with the passage of time.

References

• accountingcoach.com: Introduction to depreciation
• Investopedia.com: Depreciation