ACCOUNTING FOR DEPRECIATION

ACCOUNTING FOR DEPRECIATION

 

Depreciation is an estimate of the loss in value of a fixed asset over its expected working life. Most fixed assets lose value over time. The accounts of a business should show a fair view of the financial position so it is necessary to record this loss in value.

In the Income Statement depreciation of fixed assets will appear with the other expenses and the net profit will be reduced. In the Balance Sheet the fixed assets will be shown at a value below cost price, the written-down value, or book value, which is the cost minus the amount of depreciation up to that date.

Fixed assets are purchased to enable the business to earn profits over several years. It would not, therefore, be correct to charge the total cost against the profits of one year only. Depreciation enables the cost of a fixed asset to be spread over all the years which will benefit from the use of the asset. This is an application of the matching concept, as the cost is matched against the sales of the years which benefit from the use of the fixed asset.

Depreciation is essentially an estimate of the loss in value of a fixed asset: the exact amount of depreciation can only be calculated when the asset is sold. It is also important to remember that depreciation does not involve any actual money going out of the business - it is a non-monetary expense. Because it is charged in the Income Statement, depreciation will reduce the net profit to a more realistic figure. This is an application of the prudence concept. If depreciation is not taken into account the net profit will be over-stated, which could result in the owner of the business making excessive cash drawings which the business cannot really afford. This concept is also applied in the Balance Sheet when the fixed assets are not recorded at cost, but at a more prudent figure (written-down value). Just as depreciation does not involve a monetary expense, neither does it provide a cash fund for the replacement of fixed assets.