In accounting terms, depreciation is defined as the reduction of the recorded cost of a fixed asset in a systematic manner until the value of the asset becomes zero or negligible.
Depreciation is an accounting method of allocating the cost of a tangible or physical asset over its useful life or life expectancy.
Depreciation represents how much of an asset’s value has been used up.
Depreciating assets helps companies earn revenue from an asset while expensing a portion of its cost each year the asset is in use. If not taken into account, it can greatly affect profits.
What if you do not Calculate Depreciation in your Business?
After having a general grasp of depreciation in the realm of accounting. So now you need to grasp the crucial role of estimating asset depreciation to help the firm. If the depreciation of the asset is not taken into consideration, various problems will occur. Of course, this has a negative influence on your business. Here’s what may happen if you don’t account for asset depreciation.
Distorted Business Value
If you do not appropriately depreciate your capital asset worth, you will not perceive its true value. It will eventually lead to inaccuracies in the company’s financial status. In the books of accounting, the value of an asset will be overstated. If the asset value is more than the real value, the profit on the books is greater.
At the same time, failure to depreciate can occasionally mask corporate losses. This is bad for your business since the uncalculated profit and loss will harm its health. Furthermore, you will confuse prospective investors owing to profit unpredictability, and you will be unable to increase your capital.
Because your profit is overestimated if depreciation is not calculated, your return tax may exceed the initial amount you must pay. Aside from that, there will be inaccuracies in capital costs deduction for tax returns. If it’s only a simple arithmetic error, it won’t be a problem. The tax agency can resolve the issue without contacting you. Assume, however, that there are significant discrepancies in tax return calculation. In that situation, the tax agency may launch a formal inquiry into your company and re-audit the amount of your tax return. Once again, your company’s reputation is at stake.
Inappropriate Asset Utilization Period
You won’t know when to replace assets and maximize their use time if depreciation isn’t estimated or even considered. You may be late in replacing assets that have lost productivity. It will determine the course of your company’s operations. It gets much worse if you don’t plan ahead of time.
Importance of Depreciation in your Business
- Depreciation is important for determining true profit or loss incurred by a business. If depreciation is not charged, then the profit will be artificially inflated and it would be difficult to know the exact profit and the business performance.
- Assets need to be replaced after some time due to wear and tear, obsolescence, or depletion.
- Companies need to follow directives provided by the Companies Act, which states that depreciation should be charged before any distribution of profits as dividends.
Depreciation is calculated using 3 Primary Inputs:
- Cost of asset, which includes taxes, shipping, and preparation/setup costs.
- The useful life of a fixed asset is the time span during which the organization deems it to be productive. The fixed asset is no longer cost-effective to operate when its useful life has expired.
- Salvage/Scrap Value– After the fixed asset’s useful life has expired, the corporation may consider selling it for a lower price. This is referred to as the asset’s salvage value.
Types of Depreciation
Straight-line depreciation: Straight-line depreciation is the most popular and simplest technique of depreciation. You deduct the asset’s cost from the expected salvage or scrap value at the end of its useful life, then divide that value by the asset’s useful life.
(Cost of asset – Scrap value of asset) / Useful life of asset = Depreciation
Written Down Value method: The Written down Value method is a depreciation technique that applies a consistent rate of depreciation to the net book value of assets each year, resulting in more depreciation expenses recognised in the early years of the asset’s life and less depreciation recognised in the later years of the asset’s life. In brief, this strategy systematically accelerates the recognition of depreciation charges and assists enterprises in recognising greater depreciation in the early years. It is often referred to as the Diminishing Balance Method or the Declining Balance Method.
(Cost of Asset – Salvage Value of the Asset) * Rate of Depreciation in %