Depreciation

Understanding Depreciation

• Depreciation is the process of allocating the cost of a tangible asset over its useful life, which could be several accounting periods.
• The main purpose of depreciation is to reflect the usage, wear and tear, or obsolescence of fixed assets in the financial statements.
• Unlike other expenses, depreciation does not involve an actual cash outflow but only affects the book value of the assets and the profits.
• Depreciation is a non-cash expense that reduces a company’s earnings before tax and, consequently, its tax expense.

Methods of Depreciation

• Straight-Line Method: This is the simplest and most commonly used method. It spreads the cost of the asset evenly over its useful life. The annual depreciation expense is calculated by dividing the acquisition cost of the asset by its estimated useful life.
• Reducing Balance Method: Here, a fixed percentage is applied to the diminishing value of the asset each year. This method results in higher depreciation charges in the early years of the asset’s life, which gradually decrease over time.
• Units of Production Method: This method bases the depreciation on the actual usage or production of the asset. If the asset is more heavily used, it will depreciate faster.

Importance of Depreciation

• Accurate representation of depreciation in the financial statements is essential to reflect a true and fair view of the business’s financial health.
• Calculating depreciation allows businesses to match the cost of the asset with the revenue it generates over its useful life, adhering to the accrual concept of accounting.
• Depreciation has tax implications because it reduces taxable income, providing tax relief to businesses.
• Depreciation helps companies plan for the replacement of their assets by gathering information on how rapidly their assets lose value.