Introduction
Depreciation is a cost estimation method for accounting for the worth of a long-term asset over its useful life. Depreciation is used to spread the cost of a tangible asset over the accounting periods in which the asset is used.
There are some questions surrounding this topic that are essential to explore. For instance, what are the tax implications of depreciation? What are the different depreciation methods, and how can they be used to calculate the amount? What are the best practices for managing depreciation? How does depreciation help to ensure a company’s financial health? Each of these questions will be explored in more detail to understand the concept of depreciation fully.
Main Body
Since antiquity, depreciation has been utilized for cost apportionment. Initially, the idea was developed by the Greek philosopher Aristotle, who believed that the value of an asset declined over time (Crafts & Woltjer, 2019). By the 19th century, Italian economist Vilfredo Pareto formalized this notion and proposed that the cost of an asset be distributed over its useful life. This proposal was developed further by Karl Marx, who argued that the cost of an asset should be spread out over its useful life, as opposed to being written off in the year of purchase (Crafts & Woltjer, 2019). In the modern age, accountants have adopted this concept, which companies now utilize to accurately reflect the cost of long-term assets in their financial reporting.
The tax implications of depreciation are important to consider. The first tax implication of depreciation is that it reduces taxable income. When a business depreciates an asset, the cost of the asset is spread over multiple years, reducing the amount of taxable income in the current year. Thus, businesses can lower their taxes in the current year and defer taxes to future years. Secondly, depreciation can offset the income from the asset’s sale. When an asset is sold, any depreciation claimed can be used to offset the gain from the sale. This reduces the taxable income from the sale and can result in a lower tax bill for the business (Crafts & Woltjer, 2019). Moreover, depreciation can be utilized to increase the tax basis of an asset. When an asset is sold, the asset’s tax basis is used to calculate the gain or loss from the sale. An asset’s tax basis is raised through depreciation, which lowers the gain from sale and may lead to a smaller tax bill.
The most common depreciation methods are straight-line, double-declining balance, and units-of-production depreciation. Straight-line depreciation is the simplest and most widely used method of depreciation. It is calculated by dividing the cost of an asset minus its salvage value by its expected useful life (Boyko et al., 2019). This creates a fixed depreciation expense for each year of the asset’s life. Straight-line depreciation is best used for assets that have actual usage over their lifetime, such as office furniture or computers (Boyko et al., 2019). Double-declining balance depreciation is a method of accelerated depreciation. It is calculated by multiplying the asset’s book value at the start of the year by a predetermined depreciation rate that is twice the straight-line rate. The resulting depreciation charge is then subtracted from the asset’s book value to arrive at the book value for the following year (Boyko et al., 2019). This method is most suited for assets with a high rate of obsolescence or deterioration.
Units-of-production depreciation is a depreciation method used to calculate the depreciation of an asset based on its usage. It is calculated by dividing the total cost of the asset by its expected lifetime usage. The depreciation amount is then allocated evenly over the asset’s estimated useful life or until the asset is fully depreciated. This method is typically used when the asset is used for a specific purpose, such as production or transportation, and its expected lifetime usage can be estimated (Birjukov et al., 2019). This method is used when the asset’s usage can be easily monitored and tracked, such as a machine or vehicle.
Companies should manage depreciation to properly control their assets. This can be accomplished by estimating the asset’s expected useful life and comparing it to the useful life set by the IRS or other regulatory bodies. Useful life is the estimated time an asset can be used or the period over which its benefits are expected to be realized. The IRS sets a useful life for certain assets that it considers depreciable, but companies can also estimate the useful life of other assets (Arcuri et al., 2020). Moreover, a firm must select the most appropriate depreciation technique after considering the asset’s characteristics and the company’s financial needs. It should consider the asset’s purchase price, estimated useful life, and residual value.
In addition, a company should monitor the asset’s condition to determine whether the estimated useful life and residual value are still accurate. If the asset’s condition deteriorates faster than expected, the depreciation expense should be adjusted accordingly. If the asset’s condition improves unexpectedly, the depreciation expense should be adjusted to reflect this (Arcuri et al., 2020). Accurately recording the depreciation expense in the company’s books of accounts is essential to ensure that the asset’s value is properly reflected in the financial statements. Thus, the information can be readily retrieved when required.
Depreciation is an important factor in ensuring a company’s financial health. It helps to spread out the cost of large asset purchases over a longer period, which can help boost profitability and cash flow (Arcuri et al., 2020). This is important because it allows a company to reinvest its profits into new projects and operations instead of paying for expensive upfront asset costs. Moreover, depreciation can also help a company to avoid taking on too much debt. By spreading the cost of an asset purchase over a longer period, a company can avoid taking on large amounts of debt to pay for the purchase (Arcuri et al., 2020).
This can help to ensure that the company remains financially healthy and can continue to reinvest its profits into new projects instead of having to devote a large portion of its profits to debt repayment. Finally, depreciation can help to ensure a company’s financial health by ensuring that the company can accurately report its profits and losses on its financial statements (Arcuri et al., 2020). Depreciation is an accounting tool that allows a company to report the value of its assets over time accurately. This helps to ensure that their financial statements are accurate and can be relied upon when making decisions about the company’s financial health.
Conclusion
To sum up, depreciation is essential to a company’s financial management. It allows them to spread out the cost of purchasing large assets over a longer period, reducing their taxable income and increasing their cash flow. Companies should keep track of their assets’ estimated useful life and residual value to ensure they accurately report their profits and losses. Companies can ensure their financial health and profitability by monitoring their assets and following best practices for depreciation.
References
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Birjukov, A., Dobryshkin, E., Kravchenko, I., & Glinskiy, M. (2019). Optimization of management decisions for choosing the strategy for enterprise fixed assets reproduction. Engineering for Rural Development. Web.
Boyko, A. A., Kukartsev, V. V., Smolina, E. S., Tynchenko, V. S., Shamlitskiy, Y. I., & Fedorova, N. V. (2019). Imitation-dynamic model of amortization of reproductive effect with different methods of calculation. Journal of Physics: Conference Series, 1353(1). Web.
Crafts, N., & Woltjer, P. (2019). Growth Accounting in Economic History: Findings, lessons, and new directions. Journal of Economic Surveys, 35(3), 670–696. Web.