Discuss The Importance Of Depreciation. Essay, Research Paper
Title: Discuss the importance of depreciation expenses.
Depreciation as a concept and in practice plays a very important role in a company?s cash flow hence in funding. The reason?s are basically two, firstly because depreciation is a way of self finance for an organization and secondly because is a way of decreasing taxes that the government claims as the company doesn?t have to pay taxes on depreciation which consequently enlarges the cash flow of the company.
As a term depreciation in accounting is the process of allocating the cost of a capital asset over the period of its useful life. Depreciation takes into account the decrease in the service potential of capital assets invested in a business venture, resulting from such causes as physical wear and tear in ordinary use, deterioration by natural elements or obsolescence caused by technological changes. Basically depreciation is a loss in value or a diminishment in market price of a good always taking the time factor into account. Depreciation is a rate of change in value in an asset fixed or current compared to the present value of that asset.
For example if a company purchases machinery for the production of a certain product the management must take under consideration the equipment?s life cycle, meaning that this machinery has a certain period of time in which it can contribute to the production before it becomes useless. Useless in a sense of a newer machine will be invented in some years which will be probably faster or more capable to produce better quality. The time factor of course always varies depending on the asset. For example the usefulness of a computer may be three years before it needs replacing, as for a building may be fifty years.
A Mercedes van for instance in year 2000 could be purchased at the value of 13 million drachmas and its productive life span before it needs to be replaced will probably be 8 years. After the 8 years the van purchased would cease from being of any productive use to the company and if it needs to be resoled its market value would have depreciated drastically due to the time fade from the initial purchase. Its devaluation is its year zero value less an annual percentage of the devaluation process updated annually.
But depreciation doesn?t apply only to current assets but also is applicable to fixed assets as well. Buildings are losing their value too taking the time scale factor under consideration again. If a new building in year 1980 was valued 100 million drachmas as a newly built structure its value by the year 2030 will be definitely decreased by the depreciation rate estimated.
The most widely used method to calculate depreciation is the so called straight line method, in which the rate of depreciation is constant for the entire working life of the capital assets. Thus, if a machine cost 1 million 100 thousand drachmas and is assumed to have a 10 year useful life and a scrap value of 100 thousand drachmas at the end of 10 years, the amount of annual depreciation would be 100 thousand drachmas and the annual depreciation rate 10 per cent. Which is the annual depreciation divided by cost minus scrap value.
Because depreciation is subtracted from the assets of a financial statement it is not a subject to taxation therefore the company has automatically achieved a higher cash flow status by depreciating its assets, the worth of its capital value. This can be visible from the following cash flow calculation.
CASH FLOW CALCULATION
Depreciation Depreciation No
Accounting basis Cash basis depreciat.
Sales 2400 2400 2400
Cost of goods
Sold. 1600 1600 1600
800 800 800
Expenses 300 300 300
500 500 500
Depreciation 200 200 0
300 300 500
Taxes. (40%) 120 120 200
Earnings 180 380 300
+ Depreciation 200 0 0
Cash flow 380 380 300
In the first and second row because depreciation is included the cash and accounting sum of depreciation is not taxed this leaves the company with more cash flow compared to the third column of the calculation sheet where depreciation is not included.
With this form of saving the company is capable of having greater financial flexibility in the industry is involved in and also it ensures the replacement of the necessary current and fixed assets needed for its production purposes.
One of the most effective ways for a company to be financed this days is by self financing and since depreciation offer this capability and is a retained cash for future asset replacement it is a form of self financing.
?Depreciation and wasting assets and their treatment in assessing annual profit and loss? 1976 Percy. D. Leake.
?Depreciation and investment credit manual? 1986 Martin. E. Holbrook.