Depreciation (accountancy)
Depreciation in accountancy refers to the systematic reduction in the value of an asset over time, primarily due to factors like wear and tear or obsolescence. This process is crucial for accurately assessing an organization's financial standing, particularly in calculating total assets and liabilities. For instance, when a company faces bankruptcy, understanding the depreciated value of its physical assets, such as office furniture, becomes vital for estimating what can be liquidated to pay creditors.
Depreciation calculations typically begin when an asset is put into service, and various methods exist for calculating these values, including the straight-line method, which allocates the depreciable amount evenly over the asset’s useful life. Generally Accepted Accounting Principles (GAAP) guide these calculations, which can vary by region. The implications of depreciation extend beyond accounting, affecting tax calculations and the overall financial strategy of an organization. Understanding depreciation is essential for businesses to manage their overhead costs effectively, as it provides insight into the hidden costs associated with long-term assets.
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Depreciation (accountancy)
The concept of depreciation is used in the field of accountancy to describe the decline in value experienced by an asset over time. This decline can be attributable to a number of factors, including wear and tear, as in the case of tools, which deteriorate each time they are used, or the passage of time, as in the case of books, which may be less relevant or even less accurate several years after they were published. Accountants keep track of depreciation and include it in their calculations of the total assets and liabilities of an organization. This can be important in situations such as bankruptcy—a company trying to pay off its creditors might have no cash in the bank but still own its office furniture—the age of the furniture would be used to estimate its actual value after accounting for depreciation since the time it went into service.
Background
Depreciation calculations usually have their starting point at the time when the asset is placed into service for the organization. Therefore, if a company purchased a fleet of new delivery vans in August but did not take possession of them or start using them until November, then no depreciation values would be calculated for September or October. A common practice is for a particular type of article to have a generally accepted lifespan of expected use under what are known as the generally accepted accounting principles (GAAP). GAAP vary from country to country and from region to region and are often influenced, if not explicitly dictated, by laws in the relevant jurisdiction. GAAP might advise, for example, that books acquired by a library have an average lifespan of ten years. To calculate the depreciation on the books during their lifespan, then, their value at the time of being placed into service would be divided by the number of years in their lifespan.
For example, if a library bought a set of encyclopedias for five thousand dollars and GAAP indicated the encyclopedias have a lifespan of ten years, then dividing five thousand by ten years would yield an annual depreciation value of five hundred dollars. Therefore, each year, the library could note in its financial reports that it incurred a five hundred dollar depreciation. This often has tax implications, in addition to its importance for accurately representing the financial state of the organization. There are also a variety of different methods that can be used to calculate the amount of depreciation each year, such as the percentage method and the declining balance approach. The calculation method used in a given context may be a matter of custom or may be specified by regulations.
Overview
One of the main benefits derived from calculating the depreciation of goods is that it makes it possible to arrive at a more accurate figure for the overhead costs required to produce a particular product or service. Traditional types of overhead such as energy costs, employee salaries, and so forth are fairly simple to determine, not least because they generate regular bills that must be paid—electricity bills, water bills, and employee payroll. With these forms of documentation readily at hand, it is simple to calculate what percentage of a product’s cost covers employee wages, utility bills, or other categories. This, however, leaves out the wear and tear on the machinery that produces the company’s products, as well as the office equipment and furniture used by the employees as they participate in the creation of those products. When reconciling the balance sheet for the company, it would be extremely difficult and haphazard to try to determine what percentage of the cost of the company’s products can be traced back to (for example) the wear and tear on the company’s computer network. To make this task easier, accountants use depreciation values as a means of indicating, on average, the degree to which organizational assets deteriorate as they are used, even when they are not consumed, as are assets such as printer paper or automobile fuel.
One method of depreciation that has been adopted in many organizations is known as straight line depreciation. Under this method, when the organization acquires an asset, it estimates how long the asset will remain in use and what that asset’s residual value will be at the end of its period of use by the organization. Then the residual value of the asset is subtracted from the asset's purchase price. This gives an amount that represents the quantity of value that will be consumed during the organization’s use of the asset. This value is then divided by the number of years the asset will be in use to determine how much depreciation should be recorded each year. For example, if a company purchased an airplane for four hundred thousand dollars and planned to use the plane for ten years and then sell it for one hundred fifty thousand dollars, the company would easily be able to find the annual depreciation using the straight line method. Subtracting the residual value, that is, the amount of value left in the plane after the company finishes using it, from the purchase price gives a result of two hundred and fifty thousand dollars. Dividing this amount by ten (the number of years the company will use the asset) gives a result of twenty-five thousand dollars of depreciation per year. The company would then list this amount on its balance sheet as a source of cash. Even though depreciation is not literally cash in the real world, including it on the balance sheet does provide a more accurate picture of the company’s finances.
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