The Concept and Practice of Depreciation

The concept and practice of depreciation plays an integral part in a company"s cash flow situation and funding. The two main reasons this occurs are that firstly depreciation is a for of self finance, and secondly because a company does not have to pay taxes on depreciation, hence excluding taxation from a cash amount which enlarges the cash flow of a company.

As a term, depreciation is defined as a loss in value, a diminishment in market price, always taking the time factor into account, because the view point of depreciation is always a rate of change in value in an asset (fixed or current) compared to the present value of that asset.

If a company purchases or rents machinery, or any sort of equipment used for production purposes, it has to take into account the purchased or rented good"s production life p, meaning that everything has a certain period of time in which it contributes to production before it is rendered useless. I use the term useless in the sense that what is produced does not bring profit to the company due to wear and tear resulting in production time loss and a lower standard of quality. The time based usefulness of an asset of course varies depending on what the asset is. If it is a van for example, its usefulness might be seven years before the van needs replacing, but if it is a building we are talking about, its usefulness may be forty years.

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For example, is a JCB digger were to be purchased in 2000 at the value of £15000, and its productive life p were to be eight years, this would mean that in eight years time, the digger purchased would cease to be of any productive use to the company which purchased it. If it were to be resoled in 2008 though, its value would have depreciated drastically due to the time lapse from the initial purchase. Its depreciation, hence its devaluation, is its year zero value less an annual percentage of the devaluation process updated annually.

Depreciation does not only apply to current assets, but also is applicable to fixed asset as well. Buildings for example lose their value too taking the time scale factor into account. If a building is purchased in 1970 as a newly built structure, its value will have definitely decreased in 2025 by the depreciation rate estimated.

The way depreciation is worked out is by subtracting the rate of depreciation (of the year in question) from the present value. The rate of depreciation varies from year to year by its power (in the process of the annual 1 multiplied by the percentage rate of depreciation) being the year number of its depreciation and its depreciation rate possibly varying from year to year.

Because depreciation is subtracted from the assets of a financial statement, it is not subject to taxation, therefore the company has automatically achieved a higher cash flow status by depreciating its assets, the worth of its capital value. We can see this in the following mock cash flow calculation (Last Page).

In the first and second row, because depreciation is included, the cash and accounting sum of depreciation is not taxed, this leaves the company with more cash flow compared to the third column of the calculation sheet where depreciation is not included.

This form of saving, or investing, not only allows a company to have a greater financial mobility in the market it is involved in, but also ensures the replacement of necessary current and fixed assets needed for production purposes.

The best way for a firm to be financed it through self finance, and since depreciation is retained cash for future asset replacement, it is a form of self financing. This saves the company paying out interest rates on bank loans for example, an external source of finance which demands a price for the service provided to the company.

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