Purpose of Depreciation
Depreciation is the accounting process of allocating the cost of tangible assets over their useful lives. This process allows businesses to account for the wear and tear or obsolescence of these assets. Here are the main purposes of depreciation:
- Expense Recognition: The primary purpose of depreciation is to match the expense of acquiring an asset to the income that the asset generates. This aligns with the matching principle in accounting, which states that revenues and their associated costs should be recognized in the same accounting period.
- Asset Value Representation: Depreciation helps in showing the correct value of the asset in the books of accounts. Over time, the value of assets reduces due to usage, wear and tear, or obsolescence. Depreciation is a method that helps to reflect this reduced value in the financial statements.
- Planning for Replacement: Depreciation helps in planning for the replacement of assets. By understanding the depreciating value of an asset, a company can start planning for its replacement when it’s at the end of its useful life.
- Tax Deduction: For many businesses, depreciation is a tax-deductible expense. By depreciating assets, a company can reduce its taxable income, leading to lower tax payments.
- Cash Flow Management: While depreciation is a non-cash expense, it’s important for cash flow management. The initial purchase of an asset may be a significant cash outflow, but depreciation spreads this cost over the asset’s useful life, providing a more accurate picture of the company’s cash flow.
In summary, the purpose of depreciation is to allocate the cost of a tangible asset over its useful life and represent its decreasing value over time, assisting in accurate financial reporting, tax computation, and business planning.
Example of the Purpose of Depreciation
Let’s consider a company named “City Express Delivery” that purchases a new delivery van for $30,000. The van has an estimated useful life of 5 years, and at the end of 5 years, it’s expected to have a salvage value of $5,000.
- Expense Recognition: City Express Delivery uses the van to deliver packages, which generates revenue for the company. Therefore, the cost of the van should be matched with the revenue it helps to create. By depreciating the van over 5 years, the company gradually recognizes the expense of the van as it generates revenue.
- Asset Value Representation: The value of the van decreases as it’s used, ages, and undergoes wear and tear. By depreciating the van on the balance sheet, the company can represent its decreasing value accurately.
- Planning for Replacement: Knowing that the van is depreciated over 5 years, City Express Delivery can start planning to replace the van as it nears the end of its useful life. This ensures the company has funds available for a replacement when needed.
- Tax Deduction: Let’s assume City Express Delivery uses straight-line depreciation. The van costs $30,000 and has a salvage value of $5,000, so the company will depreciate $5,000 per year for 5 years (($30,000 – $5,000) / 5 years). This $5,000 is a deductible expense, which reduces the company’s taxable income for each of those 5 years.
- Cash Flow Management: The initial purchase of the van was a significant cash outflow, but by depreciating the cost over the van’s useful life, the financial statements provide a more accurate picture of the company’s annual expenses and cash flow.
So in this example, City Express Delivery is able to better match its expenses to its revenue, reflect the true value of its assets, plan for replacements, reduce its taxable income, and manage its cash flow thanks to the process of depreciation.