Some Fixed Assets appreciate over time while some other ones depreciate.
Appreciation is an increase in the value of Fixed Assets. Some assets such as Premises (land and buildings) tend to rise in value over time.
Depreciation is a decrease in the value of Fixed Assets. Some assets such as Equipment (machinery) and Vehicles tend to fall in value over time.
Why some Fixed Assets depreciate?
Fixed Assets decline in value for three main reasons: usage, breakage and obsolescence.
- Normal wear and tear. Machinery used in the production process used repeatedly over time tends to wear out.
- Breakage. Motor vehicles such as cars and trucks break down and raise maintenance costs. Some of them are not possible to fix.
- Obsolescence. Technological change causes newer and better computers to become available. This decreases the demand for old versions of the products. Obsolete software becomes out-of-date hence less useful.
How is depreciation recorded in Final Accounts?
Depreciation spreads the original cost (the purchase cost) of Fixed Assets over their useful lifespan. Only the value of each year’s depreciation will be recorded as a cost (expense), not the whole purchase price of the asset. It is done in this way to avoid under recording or over recording the value of Fixed Assets.
Depreciation is first determined using one of the two main methods of calculating depreciation, either using Straight-Line Method or Reducing Balance Method.
1. Profit and Loss Account (P&L Account). Each year’s depreciation will reduce profits. Specifically, Net Profit Before Interest and TAX will be reduced by the amount of that year’s depreciation only.
2. Balance Sheet. The change in the value of Fixed Assets is shown by reassessing their value in Balance Sheet by reducing the value. The real value of Fixed Assets, or Net Book Value, is calculated in the following way:
Net Book Value = Purchase Cost of the Asset – Depreciation
Fixed Assets will retain some value until fully depreciated, or sold off.
3. Cash Flow. As depreciation is classified as a non-cash expense in Profit and Loss Account (P&L Account), there will be no changes in Cash Flow Statement or Cash Flow Forecast. It is because the amount of the annual charge for depreciation does not affect the cash flow position of the business. All that depreciation does is to spread the cost of the Fixed Asset over its useful life – it is not a physical cash payment though.
Why depreciation should be recorded in Final Accounts?
Depreciation must be recorded in order to calculate the value of a business more accurately.
While depreciation reduces the value of Fixed Assets to better reflect the true value of a firm, appreciation increases the value of Fixed Assets on another hand. It is obvious that the historic costs of purchasing Fixed Assets such as Equipment and vehicles are unlikely to be equal to their current market value as the time pass by. Therefore, managers will be able to realistically assess the value of what the business owns.
By including depreciation, planning for replacement of crucial Fixed Assets will be easier as provisions will be made for purchasing new Fixed Assets in the future. Old Fixed Assets will eventually need to be replaced.
