Importance of Depreciation
All the assets that a company possesses either appreciate or depreciate in value. Appreciation occurs when the value of the asset increases as time passes, such as real estate. Depreciation takes place when the value of an asset goes down due to time, wear and tear, or obsolescence. Such assets can include equipment and machinery. Assets need to be evaluated as to their market value yearly. This is known as the method of depreciating the asset.
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Significance
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The premise on which the concept of depreciation is based is that the asset should annually be brought to the value that it would fetch in the market if it were to be sold today. This way the company is able to ward off losses in the actual event of a sale.
For example, let's say an asset was bought for $12,000 and was valued by the company at that price until the asset stopped working after five years. When the company has the item appraised to determine its worth, it may be shocked to realize that the asset is now, due to wear and tear, valued at only $2,000. The company suffers a loss to the extent of $10,000. This situation could have been avoided had the company provided for depreciation during the five years.
Features
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When the value of the asset is shown at its depreciated value, the financial statements of the company always reflect a true and clear picture of its standing. Everyday advances in technology are made and newer products are available in the market. Due to this, the value of the asset that a company possesses goes down. Also, when an asset is constantly used in production, owing to wear and tear it is not able to function as well as it did when it was newly purchased. Here too, the asset’s value is said to have gone down. Tracking an item's depreciation shows the correct asset value each year.
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Time Frame
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A company should depreciate its assets annually or during the preparation of its financial statements.
Benefits
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There are two main benefits of depreciating assets. First, an accurate appraisal allows the asset to be recorded in the company’s financial statements at the value that it would command in the market if it were to be sold. This way, should an actual sale take place, the company does not incur a loss.
Secondly, the company does not have to pay taxes on provisions for depreciation. The money saved can be either invested back in the company for expansion purposes or distributed to equity holders as dividends.
Types
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There are several methods that the company can adopt in deprecating the value of its assets. Each have their respective shares of merits and demerits.
The “straight line method,” the oldest method, depreciates an asset at a constant rate over its productive and useful life. The flaw here is that the value of the asset declines rapidly with the passage of time. By depreciating the asset by the same sum each year, the company enjoys benefits in the initial year and suffers a loss in the later years when the asset is actually sold off.
The “units of production method” depreciates the asset as per the volume of produce or the miles travelled or its hours in operation. If the item is not used fully in the first few years, this method could be a drawback; also, the depreciation value is significantly less. However, by the time the asset is utilized, its value would have declined considerably due to new products being available in the market.
The “declining method” is one where the value of the asset is reduced at a constant rate each year based on the book value of the asset at the beginning of the year. The depreciation amount in the initial years is greater than the amount in later years.
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References
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