Depreciation is a familiar word for each and every businesses and it can have a huge part to play in the companies final accounts. The calculation of depreciation is simply the assessment and evaluation of wear and tear of an asset and calculating its present market value whether it is machinery used in the industry or the vehicle used for transporting goods. When put in other words, depreciation can be applicable to each and every fixed asset the business owns. There are 4 ways in which a company can calculate depreciation and they are
1. Straight line method: This is one of the most common and simplest ways of calculating depreciation where the amount of depreciation deducted from the market value of the fixed asset is same every year throughout the life of that particular fixed asset.
2. Sum of years digits method: This is one of the methods under which depreciation is calculated under the assumption that a higher deduction is to be made in the early days of the fixed assets life which should then be gradually reduced over the years.
3. Unit of production method: This method calculates depreciation expenses as per the number of hours or number of units that have been produced by the asset during the year.
4. Double declining balance method: Under this method depreciation amount is fixed under the notion that the productivity of the fixed asset is higher in the early years of its operations and because of that a higher amount is depreciated in the initial year and it gradually decreases year after year.
Calculation of depreciation is important for businesses because it allows them to identify and ascertain the true value of the asset and this also helps the companies to look at the life of these assets and when the depreciated asset value crosses the assets purchasing value companies can take actions to get a replacement so that there are no broken machines and no shut down of operations which can affect the organizations productivity and in the end it translates to reduction in profit.
Even though the calculation of depreciation can reduce the market value of the company’s fixed asset, there are still some added advantages that organizations can have by calculating depreciation like
1. Valuation of Asset: Calculation of depreciation helps companies to closely monitor the value of assets and record it accurately. This helps the business to take critical and crucial decisions when it comes to these fixed assets and adjusting and fixing their values accordingly.
2. Reduction in Tax: Depreciation can help the company to get tax reduction. When the company has high revenue shown in its book then they will have to pay more tax. The depreciation expenses will reduce the company’s revenue and when there is only less revenue to show you will only need to pay less tax.
Even if depreciation has its advantages and uses, it has got its fair share of disadvantages also and it generally is not the fault or disadvantage of the concept of depreciation as such but it is rather the disadvantages in the different methods that are used for calculating depreciation. The 4 above mentioned methods of calculating depreciation calculates the value of depreciation under different assumptions and the first issue that arises is the lack of uniformity and the added advantages of using some methods when compared to the others. For example, if we take the straight line method which assumes the value of depreciation is same throughout the entirety of the assets life cannot be proved scientifically and the life expectancy and current and future market value of an asset cannot be unmistakably calculated.