3.4 Final Accounts HL

This is where DEPRECIATION comes into play. In accounting, we must put the original purchase price on the balance sheet, even if this does not reflect the current market value of the asset. We can create 'contra-accounts' that work directly opposite an asset to show its current book value.

We can use 2 methods of depreciation: straight line and reducing balance.

In trying to understand the concept of depreciation, consider the fact that all assets have a useful life span and that at a particular point they start losing value and usefulness. Eventually these assets will no longer function and we will discard them. A perfect example is a brand new car that over the years is used and serves the purpose of transporting you and your family wherever you want to go. However, after five or 10 years the car starts to develop engine trouble every once in a while and perhaps the doors stop opening and closing as well as they used to in the past. We can therefore say that the car has started to depreciate in its value and its usefulness has decreased.

In accounting, the concept of depreciation is applied to all assets that are used in the production process. The amount of depreciation is considered a cost that is spread over the useful life of the asset. Therefore, in accounting, the loss of usefulness is offset against the revenue in each period of the assets useful life.

It should be clear that depreciation is only an estimate. Certain assets depreciation is value faster than other. For example a car that is used as a taxi will depreciate in both value and usefulness faster than an office building, due to the very nature of wear and tear. Because of the loss in value, depreciation is allocated as an expense over the assets lifespan.

If you came upon the conclusion that Price times quantity equals revenue and revenue less costs or expenses equal profit, then the higher the costs or expenses the higher profits. Depreciation is a non-cash expense and sometimes represents that largest difference between net income and cash flow from operations. As an expense it is tax deductible and therefore, it becomes clear that the declaration of depreciation will increase the Business Organizations profitability.

In calculating the depreciating value of an asset, there are different methods used to estimate this loss of usefulness. Because of the temptation to overstate depreciation, there are published guidelines on the depreciation rates for various assets.

Most accounting practices require that the depreciation method result in a rational determination of the assets useful life. However, because of the difficulty in estimation and shorter useful life spans, accelerated depreciation implies that a greater depreciation will take place in the earlier years of the assets useful life. Nevertheless, the total depreciation would be the same in both the straight-line and accelerated depreciation method.

There are various acceleration methods that will all produce various results. The Reducing balance method is a fixed-percentage-of-declining-balance depreciation.