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Understanding Asset and Depreciation
By Enabliser Aggyey
In my very first accounting class I was taught that asset is equal to the sum of liability and the capital in a company.
Asset = Capital + Liability
It simply means a total acquisition of a company is nothing but its assets. According to International Accounting Standards Board (IASB) "An asset is a resource controlled by the enterprise as a result of past events and from which future economic benefits are expected to flow to the enterprise." In simple words whatever an enterprise owns and uses to run their day today business is called asset. On a broader classification all asset can be divide into two categories tangible asset and intangible asset. To make it simple to understand we can say the assets that we can see and touch are tangible Asset, whereas nonphysical assets are intangible assets, like rights, patents, goodwill etc.
Tangible assets can further be divided into liquid asset, current asset, and fixed assets etc. Current asset are cash in hand and other assets are those which can be converted in to cash or consumed with in a year or a production cycle. Whereas fixed asset or non-current asset are the acquisitions by the company for the long term and will be used to generate profit and keep operating for the long run.
Fixed asset includes land, building, tools, furniture, machinery etc. Fixed asset, apart from land, is written off from the book against the profit for the expected life of respected asset. This process of writing off the asset from the books against the profit is called Depreciation.
Depreciation can be viewed, as two related, but very different concepts:
- Decrease in the fair value of the asset in the due course of time.
- Allocation of the cost of the asset to the period as per usage.
First one affects the net value of the company whereas the second affects net profit. All depreciation method used by companies around the globe are based on any one of the above classification of depreciation. There are lots of the depreciation methods used by firms but most common of them are straight line, declining balance, activity depreciation, units of production method.
Straight line method and declining balance method are decreasing the fair value of the assets in the due course of time. Activity depreciation and unit of production method are allocating the cost of the asset as per there usage.
Straight line Method: This is one of the simplest and most widely used depreciation method. In this the salvage value of the asset is determined at the end of the life of the asset and the remaining value of the asset is equally distributed over the estimated life of the asset. Salvage value is the scrap value of the asset that it will be sold off at the end of its life. So when you are following this method, the value of the asset at the end of its life will be the salvage value. The formula to calculate the depreciation will be: Period can be year, month, weak etc.
Some companies are using a different formula for straight line depreciation method:
Although both formulas will provide the same amount of depreciation each month and the net value of the asset at the end of the estimated life of the asset will be the salvage value.
Declining balance method: Another widely used depreciation method is declining balance method. In this method the asset will be depreciated more in first period and the depreciation amount will decrease with each depreciation period. Hence some people suggest that this depreciation method is more realistic as the asset will depreciate more when it’s new and depreciation amount will reduce with each depreciation period and the asset will depreciate less when it is old.
This method is also important is the cases where we do not want the asset value to go into negatives or less than its salvage value.
Activity Depreciation: In this depreciation method the value of the asset will be capitalized not on the basis of the life of the asset but on the basis of total activity of the asset. For example, a car is procured and the estimated miles that the car will travel in its life time is 100,000 miles. If the cost of the car is $55,000 with salvage value of $5000, then the unit depreciation rate will be; the depreciation formula will be:
In the above example if car travels 1000 miles in current depreciation period then the depreciation for current depreciation period will be: 0.5*1000 = $500.
Unit of production method: This depreciation is similar to activity depreciation method but instead of unit travel it will consider unit produced, hence the useful life of the asset will be expressed in the number of unit expected to be produced. The depreciation formula is:
Above I explained about Asset and some popular Depreciation method. In the general accounting practices companies keeps two asset values in the books. One that represents the actual value of the asset and other that will be used for the purpose of taxation. Companies can use different methods and rates for book and tax.
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