Posted on Nov 09, 2017
What is the importance of fixed asset depreciation? The depreciation of fixed assets is primarily used to allocate cost over their functional and applicable lifetime retaining their usefulness. Companies compute fixed assets depreciation for taxation and accounting purposes and also to estimate their repair and replacement costs. In this post, we will highlight methods and ways to calculate it.
Fixed assets are economic resources owned by a business, which usually cannot be easily liquidated in the year of acquisition.
Fixed Assets are representative of those assets and investments owned by the business for the long term to expand the business. Fixed assets consist of three major categories.
First and foremost Tangible assets such as land, buildings, office equipment, computers, etc. They are used and held for the longer terms by the companies and are mainly allocated for enterprise goals.
Second are the Intangible assets representing notions of value which includes goodwill or royalties. Goodwill represents the excess of value for the business over and more than the value of capital employed.
Long-term investments are held for longer terms as well with a vision of long-term gains such as shares in another company.
When it comes to Small and Medium Enterprises (SMEs), tangible fixed assets are most relevant.
Businesses that look for returns in short durations are most likely to invest in tangible assets. It could be concluded that most tangible assets do not last forever or more than the expected durations, land being the exception, and therefore the value of it dips over time, the identification and recognition of this steep fall in value is referred as depreciation and because of the double entry system it has two impacts. First, to deduct an expense from income and the second is to reduce the value of the tangible asset.
Since now we have deduced a time period and the total decline or fall in value that must be depreciated i.e. original value less residual value, a necessity of standardized rule arises to determine how much depreciation is treated as an expense during each business trading period. Out of several rules that have been formulated, among them two most common are
Straight-line method, which yields the same amount of depreciation for each trading period
Reducing balance method, which weights the amount of depreciation to the previous time periods
The straight-line method is comparatively simpler as it takes the amount to be devalued and divide it by the time period and apply that amount to each trading period.
Reducing balance takes the cost amount into the account and uses a percentage for each trading period. The percentage is selected to reduce the value of the asset to the residual value at the end of its useful life.
Since the value of an asset reduces or depreciates as it is used and faded, as it ages, or as newer models are introduced and ready to replace the existing model, it is better practice for a business to register and track depreciation from the time of purchase.
In the balance sheet, Fixed assets are included at their initial purchase cost and then depreciated throughout their useful and productive lifespan until they are sold, replaced or recorded on the balance sheet at their residual value.
The depreciation of a fixed asset is the initial cost less the residual value. It is recorded as an expense since it diminished the value of a company's total holdings.
Fixes assets such as land are the exceptions that do not depreciate as inspite of being old and used over a period of time does not affect its value.