Depreciation of fixed assets
The management of fixed assets and the processing of accounting depreciation are an essential part of the accounting process of enterprises and organizations. Depreciation of fixed assets is an important element of corporate accounts, as it significantly affects the financial statements and various financial reports. It is about the process of depreciation of fixed assets over time, because assets lose their value and effectiveness over time.
This article is intended to clarify the concept of depreciation of fixed assets and its importance in accounting.The different types of depreciation are highlighted and each type is illustrated with practical examples. In addition, the methods of accounting treatment of depreciation are reviewed, including depreciation in equal and decreasing installments. Finally, emphasis is placed on the impact of depreciation of fixed assets on financial reporting and how it is recorded in the Income Statement and other financial statements.
Definition of depreciation
It refers to the decreasing value of fixed assets (long-term property) over time. Depreciation occurs as a result of the constant use of assets, their gradual deterioration or underperformance over time. Depreciation is considered as part of the costs of using assets and is calculated for the purpose of estimating the depreciated value of assets over the expected period of their use.
In accounting, depreciation is an expense that is charged to the gross income of a company over the depreciation period. This method helps to distribute the cost of fixed assets over several accounting periods, which contributes to a better balance of the company's accounts.
The depreciation speed depends on the type of asset and the sphere of its use. Common types of depreciation can be divided into financial depreciation, technical depreciation, and natural depreciation. Each of these types has a specific method for calculating depreciation.
In short, depreciation is the process of decreasing the value of fixed assets over time and is considered an essential part in accounting for the distribution of the cost of assets over several periods.
Types of depreciation
The types of depreciation can be summarized in the following points :Financial depreciation (time depreciation)
It is calculated based on the age of the asset and its total value.
It is considered the most common and simple in accounting calculations.
For example, suppose you have a car with a total value of 100,000 pounds and an expected period of use of 5 years. The annual financial depreciation will be 20,000 pounds (100,000 pounds ÷ 5 years).
Technical depreciation (depreciation and amortization)
It is related to the rate of use of the asset and its depreciation as a result of production processes or use.
It depends on the number of hours used or production units.
For example, suppose you have a manufacturing machine that works for 10 hours a day and is expected to be used for 2,000 hours. Therefore, the technical depreciation rate will be 20% (10 hours ÷ 2,000 hours) per hour.
Natural depreciation (material depreciation)
It concerns the deterioration of materials and material components of an asset over time.
It includes the erosion of biological assets or the erosion of real estate due to exposure to environmental factors.
For example, suppose you have a building with a building deterioration of 2% per annum. So, the natural depreciation will be 2% of the original value of the building per year.
What are the methods of depreciation?
There are several ways to calculate depreciation, and below I will give you a brief description of each method and an example of how depreciation is calculated in each case:
1. Linear depreciation method:
- It is considered the most common and simple method of calculating depreciation.
- The value of the asset is divided by the period of its use to obtain a fixed annual depreciation.
- For example, suppose you have a stomach that costs 20,000 pounds and is expected to be used for 5 years. The annual linear depreciation will be 4,000 pounds (20,000 pounds ÷ 5 years).
2. Fixed-rate depreciation method
- Depreciation is calculated based on a fixed percentage of the residual value of the asset in each year.
- The fixed depreciation ratio is the opposite of the period of use of the asset.
- For example, suppose you have a machine that costs 30,000 pounds and is expected to be used for 5 years.
In the first year, the coupon depreciation will be 6,000 pounds (30,000 pounds × 1/5).
In the second year, the coupon depreciation will be 4,800 pounds (24,000 pounds × 1/5), and so on.
3. Method of depreciation by decreasing premium:
- Depreciation is calculated based on a decreasing percentage of the residual value of the asset each year.
- The decreasing ratio is the difference between 1 and the fixed depreciation ratio of the linear method.
Suppose we have a technological manufacturing equipment worth 50,000 pounds and an assumed period of use of 8 years. We will calculate the annual depreciation and the remaining annual depreciation by the method of depreciation in decreasing installments.
The first step: calculating the annual percentage of the asset.
100% ÷ 8 years = 12.5% per annum.
Step two: calculate the annual depreciation.
12.5% × 50,000 EGP = 6,250 EGP per year.
Step three: calculate the remaining annual depreciation.
In the first year: 12.5% × (50,000 EGP-6,250 EGP) = 5,468.75 EGP.
In the second year: 12.5% × (50,000 pounds - 11,718.75 pounds) = 4,648.44 pounds.
Thus, we continue to calculate the remaining annual depreciation until the eighth year.
Although we have completed the clarification of the main depreciation methods, we can add some others for perfection. There are additional methods for calculating depreciation, which include:
Method of depreciation in actual hours
- This method is used when the asset is used based on the number of working hours.
- Depreciation is calculated based on the actual number of hours for which the asset was used.
- For example, suppose you have a camera that costs 5,000 pounds and is expected to be used for 10,000 hours. If the machine is used for 1,000 hours, the annual depreciation will be 500 pounds (5,000 pounds ÷ 10,000 hours × 1,000 hours).
Combined depreciation method:
- This method is used when you have a group of similar assets.
- Depreciation is calculated for the entire group as a whole, rather than for each asset individually.
- For example, suppose you have a collection of cars with a total value of 200,000 pounds and are expected to use them for 5 years. The annual depreciation of the entire group will be calculated based on the total value and the period of use.
Remember that which depreciation method to use depends on the nature of the asset and the requirements of the company or enterprise.
Natural depreciation (material depreciation)
It concerns the deterioration of materials and material components of an asset over time.
It includes the erosion of biological assets or the erosion of real estate due to exposure to environmental factors.
For example, suppose you have a building with a building deterioration of 2% per annum. So, the natural depreciation will be 2% of the original value of the building per year.
How to depreciate an asset after maintenance
After an asset is serviced, the depreciation process can be continued Based on the updated value of the asset after maintenance. There are several ways to destroy an asset after maintenance, including:
1. Improved residual value depreciation method (RV method)
This method is based on calculating depreciation based on the residual value of the asset after maintenance, and divides this value by the expected remaining period of use. The annual ratio of the original asset can be used or adjusted to new conditions after maintenance.
2. Improved depreciation method with decreasing balances (DB method):
This method uses the same principle as the usual method of depreciation with decreasing balances, but the annual depreciation ratio is calculated based on the updated value of the asset after maintenance. Depreciation is applied to the calculated value after maintenance and distributed over the remaining period of use.
3. Depreciation method with a fixed percentage:
In this method, a fixed annual depreciation ratio is used without regard to the maintenance done on the asset. The original value is divided by the expected period of use to calculate the annual depreciation
Companies and enterprises should choose the method suitable for them and apply to their own conditions after maintenance. It may be useful to consult a professional accountant to determine the preference between the methods and apply them correctly to ensure accuracy and reliability.
What is the relationship of depreciation of fixed assets to the income statement
Depreciation of fixed assets has a close relationship with the Income Statement of enterprises, as it affects the profit and general financial results of the company. This relationship consists in the way depreciation is recorded in financial accounts and its impact on net profit.
When depreciation is calculated for fixed assets, the depreciated amount is deducted from the value of the asset over the period of its use. This amortized cost is recorded in the Income Statement under the category (depreciation costs) or (depreciation expense).
The effect of depreciation of fixed assets on the existing income is that it reduces the net profit of the company. When the depreciation cost is deducted from the income, the net profit decreases and, consequently, the amount of profit that is recorded in the income statement decreases.
Depreciation costs are considered a non-cash expense, because the company does not pay actual cash amounts when depreciation occurs. They reflect, however, the depreciation of the material value of assets over a certain period of time.
In addition, it should be noted that depreciation of fixed assets does not affect other financial statements such as the balance sheet and the cash flow statement. However, it affects the calculation of net income, and therefore affects the assessment of the company's performance and its ability to make a profit.
In general, depreciation costs are included in the financial statements of companies to provide an accurate and detailed financial picture of the company's performance and production costs. Thanks to depreciation of fixed assets, enterprises can determine the actual costs of production and assess the feasibility of projects and investments.
Depreciation should be recorded under recognized accounting standards in accordance with local and international laws and legislation. Companies must document depreciation operations and ensure compliance with strict accounting requirements.
In the end, depreciation of fixed assets is a key element in analyzing the financial performance of companies and understanding the financial impact of the use of assets over time. Depreciation of fixed assets helps to achieve several goals, including determining the fair value of assets, planning future investments and making more effective strategic decisions.
How to treat depreciation by accounting
Accounting for depreciation includes several steps to properly record and evaluate depreciation. The following is an overview of how depreciation is treated accountants:
1. Determining the method of depreciation: companies must determine the method of calculating depreciation that suits the type of fixed asset and the requirements of accounting standards. Various depreciation methods can be used, such as linear depreciation, depreciation in decreasing installments and depreciation in production units.
2. Depreciation estimation: after determining the depreciation method, the annual depreciation value of the fixed asset must be estimated. This is done by determining the annual amortized value of the asset, which is the difference between the value of the asset and its value after the depreciation period has expired.
3. Depreciation recording: depreciation is recorded in accounting records by posting the amount of depreciation from the value of the asset to the depreciation account in the income statement. This reduces the value of the fixed asset on the balance sheet and improves the accuracy of estimating the net asset value.
4. Documentation and disclosure: companies must document all the details related to depreciation operations and the information used in its estimation. The depreciation method used, the bases based on it and the amortized values are documented annually. The depreciation policy adopted must also be disclosed in the external financial reports.
5. Revaluation of depreciation: some fixed assets may require revaluation of depreciation in the event of changes in their value or assumed life. For example, if significant improvements are made to a fixed asset, the value of the asset may be increased and the remaining depreciation period adjusted. In this case, the amortized depreciation should be revalued and included in the future depreciation in accordance with the new changes.
It is important that the processes of processing depreciation are accounting accurate and conform to the applicable accounting standards. There must be supporting documents and reliable documentation for all operations related to depreciation. This ensures transparency and reliability of financial reporting and contributes to the provision of correct and accurate information to management, shareholders and other interested parties of the company.
The procedures for processing accounting depreciation vary from company to company according to accounting requirements and company policy. You should adhere to the approved accounting guidelines and consult with a qualified accountant or financial consultant to ensure their proper implementation.
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