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What is Depreciation?
Depreciation is the term used to describe reduction in asset value or assigning asset expenses to time periods of their usage.
When an asset’s value decreases, it is termed as fair value depreciation, while assigning costs to the period of use of an asset is termed as depreciation with matching principle. Fair value depreciation influences a balance sheet, whereas depreciation with matching principle can affect the net income that is reported by the business.
For small businesses that operate on fixed budgets, leveraging the advantages of depreciation can be extremely beneficial. A business can assign expenses to assets, and if an asset is expected to prove useful in the future these expenses may be deferred. The depreciation is then noted in current period cost allocation, based upon the asset cost, its expected value, and its shelf-life.
Depreciation of capital assets needs to be accurate, like any other accounting function in an organization. One of the ways in which depreciation could be streamlined is to manage each asset separately or individually in a fixed asset management system.
How do you determine the amount to be depreciated? The difference between the cost of a fixed asset and its residual value is the total amount that needs to be depreciated over the life span of the asset. The time period across which the fixed asset is to be depreciated is termed as the ‘useful economic life’ of the asset.
Accurate depreciation matters because it is applied against the total profits earned by the organization in a single accounting period. There are several methods by which to arrive at this.
Straight line depreciation method
This depreciation method operates on the principle that every accounting period in the life of the asset should reflect equal depreciation. The formula for this is as follows:
Cost of Asset – Residual Value of Asset/ Number of years of Useful Economic Life of the Asset
Points to remember in this method
> This method is effective if the benefits received from a fixed asset are expected to remain unchanging for the most part, over its useful economic life.
> This is a popular method, and one widely adopted by many companies in calculating depreciation.
Reducing balance method
This method allocates a high depreciation charge in the initial years of the asset life, but it lessens the charges as asset age increases. The formula for this method is as follows:
Depreciation = Percentage of the reducing balance
> The depreciation percentage is applied to the written-down value of the fixed asset.
> In some fixed assets, the benefits do decline over its period of useful life. Thus, this method is beneficial where the allocation of expenses matches with the pattern of benefits derived from the asset.
Financial and Accounting benefit
> Regardless of the method chosen, the total depreciation charged will remain the same because depreciation is not a method of valuation; instead, it allocates expenses.
> One of the two methods should be adopted and retained to gain the maximum benefit from depreciation over the asset’s lifetime.
> Methods may be changed if the new one displays a clear advantage in financial position.
Depreciation of Capital Assets
Some organizations may not calculate depreciation using fixed asset systems. For these organizations, generating depreciation expenses every month could probably help maintain the pattern and also help in streamlining the process, resulting in higher accuracy.
Automated accounting solutions that can better define and improve the scope of the overall method used for depreciation, and they can also help in cases where fixed asset system is not used.
Any automated system needs to be customized to the specific needs of the organization. However, most of them would:
> Identify the capital assets involved
> Calculate and generated depreciation expense per capital asset on a monthly basis
> Provide a report on the depreciation of capital assets.
Whichever method you select, make sure that depreciation practices are fully leveraged to help you improve the profitability of your business.
The Company that CPAs Recommend
Analytix Solutions is a professional full-service business support solutions provider. The company offers comprehensive and scalable accounting and bookkeeping services while leveraging its expertise, experience, and state-of-the-art infrastructure. It offers multiple services in diverse packages for companies that are seeking a trustworthy and professional partner to give their business a head start.
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