What Principles Are Being Followed in Depreciation?
In business and accounting, depreciation relates to the loss in value of fixed assets placed in operations as a function of time or asset uses. Companies charge depreciation on fixed assets periodically to match expenses of using an asset to the revenues that the asset helps generate in the same periods. Thus, depreciation is the process of allocating the cost of a fixed asset over multiple reporting periods through the economic life of the asset. Depreciation is carried out in a systematic and rational manner using appropriate depreciation methods.
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Cost Allocation
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Depreciation is a reflection of loss in value of an asset, but not a matter of asset valuation. Assets are not depreciated on the basis of their declines in the fair market value, but on the basis of a systematic way of cost allocation. The original purchase cost of an asset is allocated as charges to expenses over the economic life of an asset in multiple accounting periods. Such a cost allocation reduces an asset’s value over time but the decline in value is unrelated to any changes in the asset’s fair market value.
Matching Expense
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Another principle reason for depreciation is to match asset expenses to revenues from asset uses in the same accounting periods. The expense matching principle is one of the basic principles of accounting. Under the principle, companies should accrue and report expenses when incurred to match with revenues that the expenses help generate.
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Net Asset Value
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A principle purpose of depreciation is to determine the appropriate net value of an asset. Because an asset loses value over time as a result of wear and tear from asset uses, companies need to report the asset at its net book value on the balance sheet, in addition to stating its original purchase cost. Net book value is calculated as an asset’s original purchase cost minus the asset’s accumulated depreciation, the sum of all prior periodic depreciation. The more depreciation an asset accumulates, the less net book value of the asset is reported on the balance sheet.
Depreciation Methods
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Depreciation follows certain systematic and rational depreciation methods that seek to best match the cost of using an asset with the benefit of the asset’s use, depending on asset types and operating situations. Certain assets are more of a function of the passage of time, and thus the straight-line depreciation method is more appropriate in carrying out a cost allocation. Other assets may be more of a function of the asset uses, and thus the activity-based, or units of production, method is better in matching expense with revenue. Still some assets decline more in value in the early years of their uses, and thus the accelerated depreciation method would be most appropriate in charging an asset’s cost to depreciation expense.
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