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Discuss the importance of depreciation
Discuss the importance of depreciation
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
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
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
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.