Depreciation is an accounting tool used to reduce the value of tangible and intangible assets over time. The purpose of depreciation is to allow companies to spread out their asset acquisition and repair costs over their income statements so that their profit margins are more accurately represented.
Depreciation is a method of expense allocation rather than of valuation. Depreciation should be taken into account when valuing an asset because it reflects the decreased value that an asset incurs along with its useful life. The useful life of an asset varies by the asset type and its application but is ultimately determined by a company’s Board of Directors. Common depreciation methods include straight line, diminishing balance, and sum-of-the-years digits.
Depreciation can be calculated using one of several different methods, each of which has different effects on the accounting and financial statements. Straight-line depreciation is the most commonly used method and involves an equal periodic expense each year over the useful life of the asset. This method is used to match a companys expenses more closely to its revenues on its income statement.
Diminishing balance depreciation also matches expenses to revenues, but the rate of the annual expense decreases over the useful life of the asset. This method is usually used when the assets involved depreciate more quickly in the beginning of their life cycle. For example, computers and vehicles typically depreciate more rapidly in the early years of their useful lives, so the diminishing balance method is commonly used for these kinds of assets.
Sum-of-the-years digits is another method for calculating depreciation. This method allocates a greater portion of the total expense to the early years and a smaller portion to the later years, which is usually more accurate for assets with a long useful life. For example, buildings and manufacturing machinery typically depreciate more slowly in the early years of their life cycle, so the sum-of-the-years digits method is often used for these types of assets.
Regardless of which method of depreciation is used, the resulting expense reduces the net income of the company. As such, it should not be overlooked in the companys financial statements. Companies are also required to report their depreciation expenses for tax purposes, so it is important for them to be accurately reported.
In summary, depreciation is an accounting tool used to reduce the value of tangible and intangible assets over time. It should be taken into account when valuing an asset, as it reflects the decreased value that an asset incurs along with its useful life. Companies use depreciation to spread out their asset acquisition and repair costs over their income statements and because they are required to report their depreciation expenses for tax purposes. Different methods of calculating depreciation are available and should be chosen based on the asset type, its application and the company’s Board of Directors’ decisions. Ultimately, the expense of depreciation reduces the net income of the company and should not be overlooked in a company’s financial statements.
