The Calculation and Accounting of Depreciation for Various Kinds of Assets - Essay Example

"Accountants generally prefer to show fixed assets on the balance sheets of limited companies at their original cost, less an estimated amount of depreciation." 1.0 Introduction: Generally different accounting policies for depreciation are adopted by different commercial enterprises in order to phase out the value of the depreciable assets over the period of the useful life of the various assets. It is also necessary that the policies adopted by the company for accounting the depreciation is disclosed in the financial statements so that the analysts and other readers of the statements can appreciate the views presented in such statements. When looked in to deeply, depreciation on assets has a significant effect in the determination of the financial position of the company and the presentation of the statements for the information of the investors and general public. Depreciation is charged irrespective of the enhancement in the market value of the assets based on the cost and useful life of the assets concerned. The management of a business usually selects an appropriate method of depreciation depending on the kinds of assets employed in the business, the nature and purposes for which the assets are put to use in the business and the general conditions prevailing in the business environment. Sometimes the business may use a combination of one or more methods of charging depreciation. With this background, this paper analyses the calculation and accounting of depreciation for various kinds of assets in the light of the statement that "Accountants generally prefer to show fixed assets on the balance sheets of limited companies at their original cost, less an estimated amount of depreciation." 2.0 Current and Non-current Assets: "The assets of a business arephysical resources owned and used by the business and arelisted on the balance sheet to reflect the value." The assets are classified into two major classifications: current assts and non-current assets. Current assets are those which can be or expected to be converted into cash within a short trading cycle usually a year or so. The current assets are usually short term assets and are meant to be for the short term use of the business. Examples of current assets are cash, inventory and receivables. The non-current assets representing fixed assets that are of long term or more permanent in nature employed in the business. The non-current assets include assets like land, buildings, plant and machinery, equipments and vehicles. The non-current assets have some characteristic features that are common to this class of assets. The purpose of acquiring these assets is to use in the business as against converting into cash on a business venture. Except for the investments in land, the cost of other non-current assets is gradually written off over the period of useful life. This amount that is being written off is being treated as an expense for doing the business and is reflected as depreciation in the profit and loss statement of the business. The depreciation is a periodic charge over the respective assets. The dollar value of non-current assets is shown on the balance sheet as the original cost of the item at the time of purchase (the net asset value is calculated by deducting the accumulated depreciation from the marginal cost)(Business Victoria) 3.0 Definition of Depreciation: A precise definition of depreciation may take the following form: "Depreciation is a measure of the wearing out, consumption or other loss of value of a depreciable asset arising from use, effluxion of time or obsolescence through technology and market changes. Depreciation is allocated so as to charge a fair proportion of the depreciable amount in each accounting period during the expected useful life of the asset. Depreciation includes amortisation of assets whose useful life is predetermined. Depreciable assets are assets which (i) are expected to be used during more than one accounting period; and (ii) have a limited useful life; and (iii) are held by an enterprise for use in the production or supply of goods and services, for rental to others, or for administrative purposes and not for the purpose of sale in the ordinary course of business. Useful life is either (i) the period over which a depreciable asset is expected to be used by the enterprise; or (ii) the number of production or similar units expected to be obtained from the use of the asset by the enterprise. Depreciable amount of a depreciable asset is its historical cost, or other amount substituted for historical cost in the financial statements, less the estimated residual value." (ICAI) 4.0 Reasons for Charging Depreciation: The following are the main reasons for charging off depreciation against the value of the assets: To provide for the wear and Tear to the fixed assets caused by physical use up, corrosion, rusting and other forms of decaying To guard against the obsolescence to changes in the technology and change of fashions or innovations leading to substitute assets To meet the fall in the market prices of the assets due to fluctuations in the foreign exchange To provide for the replacement of fixed assets losing value over the period of time To insure against the damages to properties on account of natural calamities like flood, earthquakes etc and To provide for the increased requirements of the business due to expansion 5.0 Basis for Charging Depreciation: In any business usually the calculation and charging off of depreciation in respect of any accounting period takes into account the following factors: 1. Historical cost of the asset: The historical cost of an asset is represented by the money paid out by the company or the consideration in equivalent monetary terms expended by the company on the acquisition, installation and/or commissioning. The historical cost also covers the cost of additions or improvements made to the depreciable assets. There may be adjustments made to the historical cost of the assets based on changes in the long term commitments on the assets on account of currency exchange differences, price adjustments or changes in duty structures or any other similar factors. 2. Any amount substituted for the historical cost of the depreciable asset on revaluation of the asset: In the case of certain assets where there is a devaluation of the asset for some reason the depreciation needs to be calculated on the basis of the replaced value against the historical cost. 3. Expected Useful Life of the Asset: The next factor that is taken into account in the assessment of depreciation is the expected useful life of the asset. In fact this is the determining factor for the amount of depreciation that needs to be written off over the period. The useful life of a depreciable asset is shorter than its physical life and is usually estimated. The estimation of the useful life depends on many factors like the experience with the industry with such kinds of similar assets. 4. Estimated Residual Life of the Asset: The estimated residual life also plays an important role in the determination of the depreciation charge on the depreciable asset. The determination of the residual life is a difficult issue. If the firm finds the residual value very insignificant it will be taken as nil. If the asset has a significant residual value it is determined at time of acquisition of the depreciable asset or at the time of its revaluation. 6.0 Methods of Depreciation: There are several methods of calculating depreciation. The important methods of calculating depreciation on the basis of passage of time and usage of the asset are: 6.1 Straight Line Depreciation: "The simple and most commonly used, straight line depreciation is calculated by taking the purchase or acquisition price of an asset subtracted by the salvage value divided by the total productive years the asset can reasonably expect to benefit the company." (About.com) 6.2 Reducing Balance Method: "This method assumes that the depreciation charge in the early years of an asset's life should be higher than in later years. The asset must, therefore, be written off using the same percentage rate each year." (bized) The reducing balance method is more complicated than straight line method and the depreciation is calculated on the assumption that the asset loses more value in the earlier years of its useful life. 6.3 Other Methods: The other methods of writing off of depreciation are 'sinking fund method' where a saving fund account is set up to replace the asset at the end of its useful life; and 'amortization of total depreciation' where the time value of depreciation written off is taken into account. "This method of depreciation assumes that the amount you paid for the item grows over time and each successive book value estimate will gain interest. In this method the depreciation allowances are like rent and are subtracted from the present value like an ordinary annuity. Because this method is like an ordinary annuity the depreciation allowances will all be constant." (John Powell and Alan Sun). 6.4 Depreciation on Intangible Assets: "Specifically identifiable intangible assets can be acquired individually. They include patent, trademarks, copyrights, etc. A business can simply buy them. The process of expense recognition for this category of assets is referred to as amortization"(Intro to Accounting) Goodwill is another intangible asset being acquired by a company on take over of another existing concern having a good market reputation, established customers and good financial standing in the eyes of the investors that make the company one which is above average. Unlike the process of amortization involved in other intangible assets, goodwill is tested for impairment periodically. 7.0 Treatment of Depreciation in the Balance Sheet: As already observed the fixed assets include furniture and fixtures, motor vehicles, buildings, land, improvements to buildings, production machinery, equipments and any other asset put to use in the business and whose life can be assessed in terms of number of years of useful life. "All fixed assets (except land) are shown on the balance sheet at original (or historic) cost less any depreciation. Subtracting depreciation is a conservative accounting practice to reduce the possibility of overvaluation." (Esmall Office) The purpose of providing for depreciation is as follows: 1. Ascertainment of Net Earnings of an Enterprise for Any Accounting period: The foremost purpose of providing for depreciation in the accounts is to ascertain the correct net earnings of a business enterprise for an accounting period. As depreciation constitutes major non-cash business expenditure arising due to the wear and tear and obsolescence it needs to be deducted from the profits of the business to arrive at the correct earnings 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." (Basic College Accounting) Since depreciation is an allocation of cost over accounting periods, it is not directly connected to market value-or the amount that the asset would be worth if it was sold. The book value of an asset, computed as the actual cost minus the accumulated depreciation, is simply the unallocated cost of the item. The pattern of depreciation is fixed, and does not respond to changing market conditions. While the company earns revenue from using the various fixed assets if the depreciation cost matching these revenues is not charged off to the accounts then the income of the business will be overstated to that extent. If the matching concept is being followed in the business then depreciation very closely follows this concept. 2. Retention of Profits in the Business for Replacement of Assets: Assuming that no depreciation is provided for in the accounts, this would enable the owners to withdraw the whole amount of profits from the business every year or after the close of the accounting period. In that case when there is a need for replacement of the fixed assets of the business additional capital needs to be brought in to the business. "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." (Basic College Accounting) 8.0 Reflection of Asset Value in the Balance Sheet: This is a very important issue being associated with the depreciation accounting. The balance sheet represents a true and fair view of the financial affairs of the business as on any given date by exhibiting the true values of the assets and liabilities of the business. Such state of financial affairs of the companies are being studied by various classes of people like investors, shareholders, creditors and other internal and external stakeholders who are interested to ascertain the true financial situations of the companies concerned. Under these circumstances if the fixed assets in the balance sheet will be overstated if the depreciation is not provided for. It is necessary that the fixed assets should be shown in the balance sheet at part of the costs to the extent the costs are not expired. If the fixed assets are shown in the balance sheet at their full values it will amount to overstatement of the value of fixed assets. In that case the balance sheet may not reflect a true and fair view of the financial state of affairs of the business. All the items of assets and liabilities in the balance sheet are in one way or other would have influenced the cash flow of the business. However the depreciation being a non-cash expense it does not affect the cash flow except that it has the effect of reducing the value of the fixed assets over a period. "Since depreciation is an allocation of cost over accounting periods, it is not directly connected to market value-or the amount that the asset would be worth if it was sold." (Answer.Com) The book value of an asset, computed as the actual cost minus the accumulated depreciation, is simply the unallocated cost of the item. The pattern of depreciation is fixed, and does not respond to changing market conditions. Depreciation does not involve any cash flow and after the initial cash payment for the purchase of the assets, the subsequent allocation of a part of the cost as an expense is recorded by means of an accounting entry. Though depreciation is provided on the basis of the value of the assets, it is not meant to be a mechanism for replacing the asset involved. "There are no cash flows associated with depreciation, and there is no connection with any cash accumulated for replacement of the asset. The asset may or may not be replaced-this is a capital budgeting decision that is immaterial to the recognition of expense." Moreover there are more estimation involved in arriving at the rate and amounts of depreciation which depends on a number of factors like the estimated useful life of the asset which in turn depends on obsolescence, extent of maintenance, rate of use and other factors which are not precisely measurable. While there are guidelines for the determination they can not be regarded as authentic since they only are suggested ranges. The estimates are often subject to the practices prevalent in the industry. The choices of depreciation parameters and methods are usually made by the management as there are only guidelines governing the provision of depreciation. Considering the non-cash nature of depreciation and estimations involved in the calculation of the depreciation amounts the accountants are not comfortable in showing the value of fixed assets in the balance sheet as netted by the amount of depreciation. If the net value of the fixed assets only is shown without disclosing the accumulated depreciation there of the net value may only represent an approximation of the values of the fixed assets in the balance sheet instead of the actual original cost they were acquired. This is the precisely the reason that the accountants "prefer to show the fixed assets on the balance sheets of limited companies at their original cost, less an estimated amount of depreciation." This is more so in the case of limited companies as in the case of limited companies most of whose shares are listed in stock exchanges for public trading where the investors are curious to know the real value of the fixed assets vis--vis the value of the company as a whole to base their investment decisions. 9.0 Conclusion: Thus depreciation represents the cost of the assets which are consumed within an accounting period and will be regarded as a business expense for that particular period. There are different methods of charging the depreciation on various assets. Depreciation is a mechanism by which the asset cost is assigned to the period in which the asset is consumed. Depreciation does not affect the cash flow of the business. The assessment of the rates of depreciation is based on an estimation of the useful life of the asset. Because of the non-cash nature and the estimations involved in order to present a true and fair values of the fixed assets in the balance sheets of the companies the accountants prefer to show the fixed assets at gross value at their original cost less the amount of accumulated depreciation. Reference: About.com 'Straight Line Depreciation Method' http://beginnersinvest.about.com/cs/investinglessons/l/blstraightline.htm Answer.com 'Depreciation' http://www.answers.com/topic/depreciationcat=biz-fin Basic College accounting what is Depreciation and Why Do We Need to Provide for Depreciation' http://basiccollegeaccounting.com/what-is-depreciation-and-why-do-we-need-to-provide-for-depreciation/ Baized 'Worksheet on Depreciation' http://www.bized.co.uk/learn/business/accounting/busaccounts/deprec.htm Business Victoria 'Assets' http://www.business.vic.gov.au/BUSVIC/STANDARD//pc=PC_50148.html Small Office 'How to Prepare and Analyze a Balance Sheet' http://www.esmalloffice.com/SBR_template.cfmDocNumber=PL12_0200.htm Intro to Accounting 'Long Term Assets' http://www.simplestudies.com/Lesson8/L8-1.htm John Powell and Alan Sun 'Depreciation' http://education.uncc.edu/cmste/summer/2005%20Math%20Finance/Depreciation.doc Read More