Depreciation and its impact on financial statements
Depreciation and its impact on financial statements
Depreciation is the method used by companies to the allocate cost of an asset over a period of time the asset would be used to earn revenue for the business. The idea to match the cost of the asset over the period it is being used up to generate revenue is dictated by the matching concept. Companies would have to do this so that the financial statements get reported accurately.
Depreciation is done for 2 purposes
To match the revenue earned by the asset during a period and its cost.
Without distributing the cost the total assets would reflect the original cost for all the years until the asset becomes unavailable even though generally, the asset loses values over period of time.
Depreciation is usually maintained in an account called accumulated depreciation and is used to reduce the value of the asset. For example a truck that costs $10,000 to buy would be recorded as an asset and then the depreciation cost of the asset would be recorded in the accumulated depreciation account under the general asset account. In this sense the account is called a contra asset. The difference between the cost of the asset and the total of the accumulated depreciation is the net book value of the asset. This does not mean the market value of the asset or can depreciation been seen as a loss or damage to the value of the asset. In financial accounting, depreciation is just a method of allocating the cost of the assets over its expected useful life. In the case where the asset actually loses value because significant damage the value of the asset is adjusted to reflect this and would be shown separately.
Depreciation tends to be a large expense on the financial statements of companies. Accumulated depreciation account does not involve the cash account of the assets. It directly impacts the expenses thereby impacting the income statement and the earned income the company presents. The ways of applying depreciation is a common practice that covered by the Generally Accepted Accounting practices (GAAP) standards. But there are assumptions that the companies make for arriving at the depreciation value of an asset that have to be closely watched by people reading the financial statements.
The assumptions in depreciation are around the methods of calculation the companies choose for depreciation calculation and the parameters involved in the calculation. The basic calculation of depreciation involves
The cost of the asset
The salvage value of the asset
The useful life of the asset
The method used to calculate depreciation.
The cost of an asset should be the delivered and installed cost of the asset. It should be the cost involved in getting the asset to be productive for the company. A machine that the company buys would need to be installed and tuned to the company's specifications before it can be put to use for generating revenue for the company. The cost should include the money spent on these preparations for arriving at the cost of an asset.
The useful life of an asset is the period of time the company thinks it's going to use the product or the period the company thinks the product could be put to generate revenue for the company.
The salvage value is the value the company expects to realize when an asset is sold at the end of the estimated useful life of the asset. Salvage value is the market value the asset is supposed to fetch after the useful life. It is similar to the tax deduction people get on the tax returns when they donate a car, the salvage amount is determined as the current market price of the car. The salvage amount is sometimes tricky to calculate because of market conditions and demand of the product. It also depends on the industry the asset is or the amount of customization the asset has gone through and if it would have any demand on the market. Sometimes the asset could also become obsolete within the period of useful life making it very difficult to calculate the salvage value. For example software the company buys. The company might use it for 10 years but technology products usually become obsolete very soon.
Both the salvage value and useful life of an asset directly impact the depreciation calculation of an asset. Accountants should get these values as accurate as possible by consulting with the engineering department of the company. With input from engineers and analysis of past results, accountants should be able to arrive at a more accurate value.
The 2 most commonly used method of calculation is
Straight line-method of calculation is a more direct method where the depreciation amount is constant thought the life of the asset. The asset is gradually depreciated throughout the life of the asset.
Accelerated Methods of calculation depend on the straight line method for the rate of depreciation and then apply that depreciation at a faster rate. The amount of depreciation is not constant and the product depreciates faster.
The method of calculation usually depends on the type of asset. An automobile usually depreciates faster initially and hence it makes sense choosing a faster depreciation method. Companies are free to choose the method of calculation for an asset. The method of calculation directly impacts the net book value of the asset and hence the earnings. If a company is trying to cut costs and make its earnings look better it would use a straight-line method.
All these assumptions are not standardized because of the different types of assets and usually the only clue available to these assumptions is on the footnotes of the financial statements.
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