Depreciation And Its Impact On Financial Statements
Depreciation is the method used by companies to allocate the cost of an asset over
the period of time that the asset would be used to earn revenue for the business. The idea to pair the cost of an asset over the time period it is expected to generate revenue is dictated by the "Matching" concept. Companies are required to utilize this concept in order to ensure that their financial statements accurately reflect the companies' financial positions.
Depreciation serves two purposes; 1. To match the revenue earned by the asset during a particular period with its cost for the same period, 2. The lack of distributing the cost of assets over their expected lives would represent the assets at their original cost indefinitely until the asset becomes unavailable. Generally, assets lose value over time.
Depreciation is usually maintained in an account called "Accumulated Depreciation" and is used to reduce the value of assets according to their ages. For example a truck that costs $10,000 would be recorded as an asset and then the depreciation cost of the asset would be recorded in the accumulated depreciation account typically located beneath the general asset account on the balance sheet.
These accumulated depreciation accounts are known as contra-asset accounts. The difference between the cost of an asset and the total of the accumulated depreciation for that asset is what is known as the "Net Book Value" of the asset. This does not mean the market value of the asset. Nor can depreciation be viewed as a loss or damage to the value of the asset. In financial accounting, depreciation is just a method of allocating the cost of assets over their expected useful lives.
In a case where the asset actually loses value because of significant damage, the value of the asset is adjusted to reflect this and that entry would be shown separately.
Depreciation tends to be a large expense on the financial statements of most companies. Accumulated depreciation accounts do not involve the cash accounts. They directly (with the assistance of their expense account counterparts) impact expenses thereby impacting the income statement and the earned income that the companies present.
The application of depreciation on financial statements is a common practice that is covered by Generally Accepted Accounting Practices (GAAP), but there are assumptions that companies make for arriving at the depreciable value of an asset that are closely watched by those reading the financial statements.
The assumptions in depreciation involve the methods of calculation that companies choose for depreciation calculation and the parameters involved in the calculation. The basic calculation of depreciation involves: 1. The cost of the asset 2. The salvage value of the asset 3. The useful life of the asset 4. 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. That cost should include the money spent on these preparations.
The salvage value is the value the company expects to realize when an asset is sold at the end of its estimated useful life. Salvage value is the market value the asset is supposed to fetch after the useful life. It is similar to the deduction that individuals get on their tax returns when they donate a car. The salvage amount is determined to be 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 used in and the amount of customization that the asset has gone through as well as market demand.
Sometimes the asset could also become obsolete within the period of its estimated 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 that asset. Accountants should calculate these values as accuratly 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 the most accurate value.
The useful life of an asset is the period of time that the company reasonably believes it is going to use the product for or the period of time that the company thinks the product could be used to generate revenue. The 2 most commonly used methods of calculation are: 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 of these assumptions are not standardized because of the different types of assets and usually the only clue available to these assumptions is in the footnotes of the financial statements.
by: Jim Rizzolo
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