Depreciation of non-current assets

Understanding Depreciation

Depreciation is a mechanism to account for the decline in value of non-current assets due to usage, wear and tear, time or obsolescence.
Non-current assets (also known as fixed assets), such as machinery, vehicles, or buildings, lose value over time and this is reflected in the financial statements through depreciation.
The value of non-current assets is not what was paid for them, but their net book amount (cost less accumulated depreciation).

Why Depreciation Matters

Depreciation helps to match the cost of an asset to the periods in which it generates revenues or benefits.
It is an important part of accurately measuring profit or loss, as it acknowledges that a portion of the revenue earned used up part of a non-current asset.
Without accounting for depreciation, financial reports may overstate assets and net income, leading to inaccurate assessments of the business’s financial health.

Methods of Depreciation

The Straight-line method is a simple way of applying depreciation. This involves deducting the same amount from the value of the asset each year until its residual value (expected value at the end of its useful life) is reached.
The Reducing balance method applies a fixed percentage rate to the declining balance of the asset. This method is typically used for assets that lose their value faster in the earlier years of use, such as technology equipment.
The method of depreciation chosen can dramatically affect the financial statement of the business.

How Depreciation Affects Financial Statements

On the Balance Sheet, depreciation reduces the net book value of non-current assets over time.
The amount of depreciation for the year is an expense on the Income Statement, reducing the profit.
Depreciation is a non-cash expense, hence it does not affect the cash flow of a business. It is added back to the net profit during the preparation of a Cash Flow Statement in the operations section.

Key Aspects of Depreciation for Sole Traders

For sole traders, understanding how depreciation affects the value of assets and income is crucial when making business decisions or strategies.
Appreciating the implications of depreciation can help in managing assets efficiently and ensure investments are accurately represented in financial reports.
It’s also important when communicating with stakeholders, as it paints a more accurate picture of the business’s financial health.