Why Is Depreciation of Fixed Assets Important? 3 Important Points

Why some Fixed Assets depreciate?

Depreciation of fixed assets is a term that refers to the reduction in value of an asset over the period of time. It is a measure of the wear and tear of the asset caused by regular use or the passage of time.

Depreciation is a necessary accounting practice. As it provides a more accurate reflection of the asset’s value and helps businesses record their expenses and revenues.

Fixed assets, such as buildings, equipment, and machinery, are subject to depreciation. Because their value decreases over the period of time. This decrease in value is due to a variety of reasons, including normal wear and tear, obsolescence, or changes in market conditions. The process of depreciation helps to divide the cost of the asset over its useful life. So that the value of the asset on the balance sheet reflects its current value.

The process of recording depreciation in final accounts is straightforward and involves several steps.

First, the company must determine the useful life of the asset and the method of depreciation to be use. There are several methods of depreciation, including straight-line, declining balance, and sum-of-the-years’-digits.

Once the useful life and method of depreciation have been determined, the company can calculate the amount of depreciation to be recorded each year. This amount is then recorded as an expense on the company’s income statement, reducing the value of the asset on the balance sheet.

The depreciation expense is also recorded as an offset to the accumulated depreciation account, which is a contra asset account. That represents the cumulative amount of depreciation recorded for the asset over its useful life. The accumulated depreciation account is subtracted from the original cost of the asset on the balance sheet. To arrive at the net book value of the asset.

Why Is Depreciation of Fixed Assets Important?

 

Depreciation of fixed assets is an important accounting practice for several reasons.

1. 1. Accurate reflection: It provides a more accurate reflection of the asset’s value. The depreciation expense reduces the value of the asset on the balance sheet, providing a more accurate picture of the asset’s value over time.

1. 1. Record their expenses and revenues: Depreciation helps companies record their expenses and revenues. By recording depreciation as an expense, companies can properly divide the cost of the asset over its useful life. This helps to ensure that the company is recording its expenses, which can impact its tax liability and profitability.

1. 1. Manage their cash flow: Depreciation helps companies manage their cash flow. Depreciation expenses are recorded as non-cash expenses, meaning that they do not affect the company’s cash balance. This can help companies manage their cash flow more effectively. As they do not need to allocate cash to replace the asset when it reaches the end of its useful life.

How Does Depreciation Impact Financial Statements?

Depreciation has a significant impact on a company’s financial statements, including the balance sheet and income statement. On the balance sheet, the depreciation expense reduces the value of the asset, which can impact the company’s asset-to-liability ratio.

On the income statement, the depreciation expense is recorded as an operating expense, which reduces the company’s net income. This can impact the company’s profitability and tax liability.

In addition, depreciation can impact a company’s cash flow statement. The depreciation expense is record as a non-cash expense, meaning that it does not affect the company’s cash balance. This can help companies manage their cash flow more effectively. As they do not need to divide cash to replace the asset when it reaches the end of its useful life.

Conclusion

Depreciation of fixed assets is an important accounting practice that helps companies accurately reflect the asset’s value and helps businesses record their expenses and revenues.