Explanation, importance and limitations of depreciation

Depreciation is a fundamental concept of accountancy. The paper explores the importance of depreciation to me (an accountancy student) and how it could be explained to a new employee in finance department. The various limitations those are inherent in the concept and the possible means of learning more about it.

Explaining the concept to a new employee

“Depreciation is the allocation of an asset’s cost over its useful life”. (Randall, 2005)

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Businesses buy fixed asset which are used in the business for a number of years. These assets loose value with time. This is called Depreciation.

For example, a machine bought for $20,000 is only worth $15,000 after a year’s use, this reduction in value of $5,000 is our depreciation. This reduction in value is treated as an expense and is charged to the year’s profit and loss account. The cost of asset is also reduced by this amount in the balance sheet and arrived to an amount called Net Realizable Value (NRV).

Reasons for Depreciation:

As assets are used they wear out and suffer a loss in their original value.

Technological change is another factor for depreciation. As advancements are made in technology, equipments become outdated and will have to be sold for a meager amount.

Changes in fashion can eliminate the demand for a product and subsequently the fixed asset used to make that product.

Natural resources deplete as they are extracted from ground. (Lynch, 2006)

Methods of calculating depreciation:

Straight Line Method

This is the easiest method of calculating depreciation. This method evenly spreads the depreciation charge over the life of an asset. To calculate this we need three strings of information. Cost of asset, Disposal value (estimated value at the end of assets life) and estimated life of the asset. The formula which would then be used for calculation is.

Annual depreciation charge    =    Reducing Balance Method

This method of depreciation involves applying a fixed percentage to the Net book value of the Asset. Net book value is computed by deducting accumulated depreciation from the cost of the asset. The effect of this method is that the charge of depreciation is higher in the first year, and shrinks in subsequent years as the Net book value diminishes.

For e.g. lets suppose an asset was bought for $10,000 and depreciation charge is 10%. Depreciation for the year 1 would be 10,000 * 10% = $1,000.

Net book value after 1^st year is 10000 – 1000 = $9000

Depreciation for year 2 would be 9000 * 10% = $900

It could be clearly seen that depreciation has declined from year 1 $1000 to year 2 by $900.

Importance of Depreciation

Concept of depreciation is important to me as an accountancy student because this concept is an application of basic accounting principles namely the matching concept. It states that expenses should be matched with the revenues of the same period. The value of fixed assets declines with time, this decline in value is an expense and so is charged against the revenue it assisted in earning.

Depreciation is an application of prudence concept as well. The value of asset diminishes with time; financial statements should reflect this and state the asset at a value they could be expected to fetch if put to sale (Net Realizable Value) in contrast to what they were purchased for. This would give stakeholders a fair view of the business and assist them in making an informed decision about future dealing with the company.

The purpose of depreciation is to provide users with accurate and realistic information about the business, same is the purpose of every accountant and so this concept has a duty of care as it can be manipulated (see below).

Limitation and concerns

A few concerns I have about this concept is that depreciation is an estimate and can be easily manipulated. In manufacturing businesses where fixed asset have significant amount a slight variation in depreciation method can reduce depreciation expense and thus could result in an artificially inflated profit. This might mislead the prospective investors into thinking that the firm is performing well, when in reality they aren’t. This is called window dressing (Hall, Jones and Raffo, 2000)

Motivation for window dressing

To make the business look healthier than it is so as to attract outside investments, gain on stock exchange by increased share prices.

Charging high depreciation in accounts that artificially reduces the profit in order to save on government taxes.

Learning more about depreciation

Internet is a good source of information. But as everyone can write on internet without proper expertise I prefer reading online journals which are accurate and authentic. University teachers should be in the priority list as they conduct research, moreover, teaching in itself is twice learning.

Conclusion

The concept of depreciation is a symbol of many accounting conventions. Scope of which is to prepare financial statements that are accurate, factual and dependable. This concept involves responsibility accounting as manipulation can seriously affect the decision making of stakeholders. It is important that we keep ourselves updated on accounting concepts via internet, books and teachers.

References

1. Hall, Dave. Jones, Rob. Raffo, Carlo (2000). Business Studies. 2^nd Edition Causeway press ltd
2. Lynch, foulks (2006) Prepearing Financial Statements 1^st Edition Financial Trading Company.
3. Randall, Harold (2005) As and A level Accounting . 1^st Edition. Cambridge University Press.

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