Depreciation-What is it and why should I do it
Depreciation-What is it and why should I do it
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Home Page > Finance > Taxes > Depreciation-What is it and why should I do it
Depreciation-What is it and why should I do it
Posted: Apr 21, 2011 |Comments: 0
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Depreciation of an asset, such as a building or equipment is essential in financial and tax accounting. Depreciation is the valuation of the asset year over year until the useful life is exhausted. Each type of asset has a standard life that is measured in years. At the end of the life the asset is fully depreciated and the asset value at the end may have a salvage cost or none at all.
The asset is placed on the balance sheet and with the matching concept there is a reduction in cash or an increase in short or long term liabilities. Any costs associated with the asset to get it ready to use can also be considered in the original cost. In the construction of a building, the interim construction loan financing and costs can be used. In the set up of a plant or machinery in that plant, the installation of the equipment also has a cost that can be considered in the original cost.
Equipment has a useful life and helps in generating revenue. Because the revenue that the equipment generates is in future years, depreciation is utilized each year to increase the cost of goods sold. This results in a tax benefit.
Accounting for depreciation matches a depreciation expense with the amount of accumulated appreciation. The sum of the asset, minus the depreciation leaves a net book value on the balance sheet. This is offset by a depreciation expense to balance the credit and debit on the balance sheet. The expense is accounted for on the income statement, reducing the tax liability of the business (a tax accounting strategy).
There are many different methods of depreciation; the most common are straight line and accelerated. The straight line method utilizes equal depreciation adjustments over the useful life of the asset. The accelerated method depreciates much faster in the early years of the useful life. Each asset a business depreciates can utilize any method of depreciation, and similar assets on the balance sheet can utilize similar or different methods.
Maintenance and upkeep of depreciable assets may be added to the cost of the asset and depreciated as well, if the repairs extend the usefulness or the life of the asset. However, most maintenance and repair costs are not significant and are usually deducted as a straight line expense rather than a capitalization of the business.
Once the asset has been fully depreciated there is a net book value remaining (salvage value). The company can choose to sell or scrap the item, or even continue to utilize the item if the equipment is still being utilized. Either way, the equipment value and the accumulated depreciation match with one another. As an example, a $10,000 asset with a salvage value of $1,000 could be sold for $1,500. The amount of the cost of the equipment and the accumulated depreciation of $9,000 is matched and the salvage value of the sale price goes to cash while the profit of $500 goes to revenues.
Accounting for deprecation in relation to financial reporting is helpful to the business to keep more accurate records on the cost of goods sold each period it is reported. The tax accounting benefit, especially in an accelerated method, increases the amount of expenses during the period and thereby reduces a tax liability. This tax accounting is very important to businesses so that they can distribute the usefulness of the machine in making their widgets, or whatever the equipment is utilized for. For any detailed advice on how you should consider depreciation of your assets, utilize the professionals. Your company’s financial controller or your CPA can help decide which method is best for your business.
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