Resources | Subject Notes | Accounting
Non-current assets are assets that a business owns for more than one accounting period. They are used in the running of the business and are not intended for sale.
Examples of non-current assets include:
Depreciation is the systematic allocation of the cost of a non-current asset over its useful economic life. It reflects the gradual decline in the asset's value due to wear and tear, obsolescence, or usage.
It's important to note that depreciation is an accounting concept, not a physical deduction of cash.
There are several key reasons why depreciation is accounted for in accounting:
The matching principle requires that expenses are recognized in the same period as the revenues they help to generate. Non-current assets are used to generate revenue over a period of time. Depreciation allocates the cost of these assets as an expense over their useful life, matching the cost with the revenue they contribute.
Example: A delivery van is used to deliver goods and generate sales revenue. The cost of the van is allocated as an expense over the years it is used.
Without depreciation, the profit figures would be artificially inflated. The full cost of the asset would be expensed in the year of purchase, leading to an overstatement of profit in that period and an understatement in subsequent periods. Depreciation provides a more realistic picture of the profitability of the business.
Depreciation reduces the carrying value (book value) of the asset on the balance sheet. This provides a more realistic view of the asset's current value. It reflects that the asset is gradually losing value over time.
Depreciation is often tax-deductible. This reduces the taxable profit of the business, leading to lower tax liabilities. Governments allow depreciation as a way to encourage investment in capital assets.
Depreciation helps in evaluating the efficiency of asset usage. By comparing depreciation expense to revenue generated by the asset, businesses can assess whether the asset is performing effectively.
There are several methods for calculating depreciation, including the straight-line method, reducing balance method, and units of production method. The choice of method depends on the nature of the asset and the accounting policies of the business.
| Method | Formula |
|---|---|
| Straight-Line | $$\frac{Cost - Salvage Value}{Useful Life}$$ |
| Reducing Balance | $$r \times Book Value$$ (where 'r' is the depreciation rate) |
Salvage Value: This is the estimated value of the asset at the end of its useful life.
Accounting for depreciation is a crucial aspect of accounting. It provides a more accurate and realistic representation of a business's financial position and performance. It ensures the matching principle is followed, reflects the true cost of using assets, and has important tax implications.