Depreciation is an accounting concept through which businesses calculate the declining values of their assets over time. Depreciation means a fall in the value of assets with time due to use or obsolescence. It is regarded as a non-cash transaction and does not represent real cash flow.
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Depreciation is a method of accounting which is used by a business to calculate and allocate the declining costs of its tangible assets over their useful life. These assets include buildings, machinery, equipment, etc. purchased by the business in the said financial year. It basically is a non-cash transaction which entails the decline in an asset’s value with the passage of time. Long-term assets are depreciated by businesses for accounting and taxing purposes.
Depreciation is recorded as an expense and a deduction from fixed assets whenever a business prepares its financial statements. This serves the purpose of spreading the initial price of the asset over its useful life.
The way in which a business uses depreciation can have an impact on the value of a short-term investment opportunity. Although depreciation is to be expensed according to a set of rules, the management of the business can manipulate it to mislead investors and analysts. Therefore, while evaluating financial statements, it is important to be aware of various misleading assumptions and methods used by businesses.
The business’ management decides critical assumptions about how depreciation is to be expensed. The following assumptions are decided by the management:
- Rate of depreciation
- Method of depreciation
- Useful life of an asset
- Asset’s scrap value
Depreciation of an asset is inversely proportional to its scrap value and useful life. A lower rate of depreciation increases the reported earnings and book value of the business. A lower scrap value results in a higher depreciation rate and a higher scrap value results in a lower depreciation rate.
Every business chooses its preferred method for calculating its depreciation expense. The most common methods for calculating depreciation are:
- Straight-line Depreciation Method: The asset’s estimated scrap value at the end of its useful life is subtracted from its original cost. The difference is divided by the estimated number of its useful years. The same amount of depreciation is expensed by the business every year. Straight-line Depreciation = (Original cost – Scrap value) / Estimated useful life
- Accelerated Methods: The depreciation cost is written-off quicker than the straight-line method. They aim at minimizing accounting income. ‘Double Declining Balance’ is one popular accelerated method which doubles the depreciation rate of the straight-line method. Double Declining Depreciation = [(Original cost – Scrap value) / Estimated useful life] x 2
Investors and analysts must know how choosing either depreciation method will impact the income statement and balance sheet of a business in the short-term. The depreciation method can so much as affect the book value and net value asset (NAV) significantly. For instance, choosing the straight-line method will reduce earnings and increase costs and increase earnings-per-share of the business. Similarly, depreciation assumptions do not signal an improvement in the performance of the business.
Therefore, it is extremely important for investors and analysts to be aware of various tactics which businesses can use to make their financial statements more impressive than they really are.