What Is Depreciation And Why Do We Need To Provide For Depreciation

June 10th, 2006 Comments off
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WHAT IS DEPRECIATION?

Depreciation is the permanent and continuing diminution in the quality, quantity or value of an asset.

Depreciation Accounting deals with the allocation of costs of fixed assets over their useful lives. More simply, that part of cost of this asset which is being periodically (monthly) allocated as expense into the Income Statement to match the revenue the asset is generating.

 

For example, when we buy fixed asset like factory machinery, this is merely an advance payment of which we expect that this fixed asset is able to enhance or earn certain earnings for the business. Over a period of time, the fixed asset we buy will become valueless or unable to generate the necessary earnings. To reflect this continuing diminution in the value of the factory machinery, we need to apply depreciation accounting.

The reasons for depreciation are:

· Wear and tear [physical using up like corrosion, rot, rust and decay];

· Obsolescence [change of fashion or new substitutes or inventions];

· Fall in market price [foreign exchange, competition,];

· Effluxion of time [passage of time, fixed assets become less valuable];

· Physical factors [natural disasters like flood, earthquakes, excessive heat or cold];

· Inadequacy or superfluous [ business operation increased hence fixed assets inadequate ]

WHY THE NEED TO PROVIDE FOR DEPRECIATON?

  • To ascertain the net earnings/profit for an accounting period, depreciation need to be computed. Depreciation normally constitutes a major part of the expenses of the business. As the business buys fixed assets, it expects the fixed assets over the useful lives are able to generate the necessary revenues for its business. Whilst revenues being earned and if there is no allocation of depreciation cost to match these revenue, income will then be overstated. Depreciation therefore follows very closely to the matching concept;
  • The fixed assets in the Balance Sheet will be overstated if depreciation is not provided for. Only that part of the costs of fixed assets that have not expired should be reflected in the Balance sheet otherwise the financial statement will not reflect a true and fair view;
  • If depreciation is not provided for and assuming if the whole profits were withdrawn during the life of the asset, additional capital would have to be raised when it is time to replace the fixed assets. By charging depreciation against profits, the ultimate residual profit available for distribution is lowered and that funds are retained in the business for future replacement.

SALIENT POINTS TO NOTE

1. The varying depreciation rates can mean a higher or lower depreciation charge to the Income Statement. Therefore, it is very important to estimated correctly the useful lives of the fixed assets.

2. It is interesting to note that in accounting fraud, management can accelerate the depreciation charges or understate them.

3. Depreciation is in reality based on a matching concept meaning that the charge out depreciation amount is to match with the revenue that are generated from deploying these fixed assets.

4. In accounting, the depreciation charge/rate does not necessarily equal to the tax accounting treatment of depreciation. Sometimes, they differ quite drastically as a result of certain tax concession given by the Inland Revenue.

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