Depreciation is the cost allocated as expense which has the effects of reducing the value of a fixed asset during the period it is used by a business. It is a non-cash expense and need to be charged to the Profit & Loss account yearly which lowers the company’s profit which increasing free cash flow.
Fixed assets are long life. They are bought to assist in the operation of business but not with the main purpose of resale. They are in fact revenue-generating assets as they help to gain profit depending on their useful lives. Depreciable items include machinery, vehicles, buildings and fixtures. There are reasons why assets may depreciate:
- Obsolescence: Assets are replaced because new and more efficient technology has been developed.
- Depletion or Exhaustion: The values of assets such as mines, quarries and oil wells diminish due to the extraction of raw materials from them.
- Passage of Time: Assets which have limited period of life in terms of years. The term amortization instead of depreciation is often used to refer this.
- Physical Deterioration: Assets become worn out after used. It becomes less cost-effective to perform and spend more to maintain and repair.
The two most common methods used to calculate depreciation expense are:
- Straight line or Fixed Installment Method: An equal amount of depreciation over the estimated useful life of an asset is allocated for each year.
- Reducing Balance or Diminishing Balance Method: Depreciation is calculated as a fixed percentage based on the book value of an asset at the beginning of the accounting year but not the cost of the asset.
Provision for Depreciation in Financial Statements
Provision for depreciation records accumulated depreciation. It is an asset contra account, hence a credit balance as shown as a deduction from the related fixed asset in the Balance Sheet. The balance of the provision for depreciation increases with time and the book value of the fixed asset decreases with time.
Provision for depreciation account is the liability of business. By making provision for depreciation account, company’s balance sheet will reflect the current value of fixed assets.
When asset is sold, it accumulated provision for depreciation will be transfer from the credit side of provision for depreciation account. Then, we will compare it with the sale value of asset. If sale value of asset is more than the current book value of asset after adjusting from provision for depreciation, it will be profit on sale of asset.
Reasons for Including Provision for Depreciation in Financial Statements
- To match the earning revenue: The very first reason is to match the earning revenue. Depreciation is directly related to the matching concept. Matching concept is a concept that matches the expenses with related revenues. Under the matching concept, in a particular accounting period that the expenses are the cost of the assets used to earn the revenue, if there are no expenses there will be no revenues. Revenues can’t generate without expenses. Therefore, when the expenses are matched with the revenues generated in the same period, the results will be the net profit or loss for that period. Example, consider ABC Woodworks Company, a woodworking business that purchases its own custom woodworking machinery. When ABC Woodworks Company purchases a new custom piece of machinery, this new machine is durable enough to last for several years. In accounting terms, this means that the equipment is in use over several reporting periods, not just the one in which the machine was purchased.
- Technological obsolescence: Besides that, the purpose of depreciate the assets is to because of the technological obsolescence. Technological obsolescence generally occurs when a new product has been created to replace the old version. When a machine has ends its useful life, the business will need to buy another new machine to continue in order to produce goods. For an example, if the technology has been obsolete, the value of the revenue in the market will be very low. In that moment, the business will write off ( i.e. fully depreciated) the technology and the needs to buy a new and advance technology arise.
- Wear and Tear: Next, the third reason of depreciation is wear and tear. What is wear and tear? It means that the asset has physically degenerated due to wear and tear in used. The more we used the assets the greater the wear and tear would be. There are many reasons of physical deteriorate of an asset example: erosion, accident, friction etc. The wear and tear is general but it is also cause of depreciation.