Why Depreciate Fixed Assets? Effects of Depreciation
Depreciation of Fixed Assets
Fixed assets must be revalued regularly to ensure that the right cost is included in the accounting books. Depreciation is very much necessary for fixed assets because the fixed asset would lose its residual value due to the wear and tear, depletion, passage of time, obsolescence or accidents over a time period. Therefore, the actual value of the asset cannot be determined if we take the purchase amount in the books every year.
Fixed assets are major expenses of any business and have a set life period of their own when used commercially. After a certain time period they become obsolete for use, and require the business to buy that particular asset again.
In terms of realization of cash, fixed assets have a longer liquidity time period. For example, if the business has purchased land and buildings, it will take a longer time to be realized in cash. In contrast, the current assets of the company – including money receivable, inventory, etc. – have a shorter time frame to be realized in cash.
In order to reduce the burden on the business accounting bodies all over the world, the depreciation tool is used to determine the actual value of the asset and use it as a sinking fund to replace the asset in the future.
The whole process of depreciation calculation occurs at the end of the year when accounts are prepared. The calculation is a non-cash expense which is estimated or forecasted and is shown in both the profit and loss statement and the balance sheet.
Why Depreciate Fixed Assets?
The question of why fixed assets should be depreciated is a common one asked by many. The main reason for calculating depreciation is to calculate the recovery of cost that is incurred on fixed assets over their useful life. This ensures the owner’s capital is intact. By following the process, future provisions can be made for replacement costs when the present asset is retired from the business.
The true value of an asset can be ascertained if depreciation is taken into account. If depreciation is not calculated, the asset value shown in the accounting books would be higher than the actual or true value.
Moreover, depreciation is often added to the cost of production so as to find out the actual cost of production. This is because machinery and equipment used to produce the product often incurs some sort of wear and tear of the asset. This must be calculated and added to the cost of producing the product.
Thirdly, depreciation must be calculated to find out the correct profit of the year and to find out the actual position of the business through the balance sheet. Unless the depreciation value is calculated and considered like other expenses, the true profit or loss of the business cannot be ascertained.
Lastly, as per Company Act statutes, a company cannot declare dividends until it has calculated depreciation and charged it to the books.
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