Business Finance – Depreciation Notes

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Emma Rudd BMA
Business Finance ­ Depreciation _
Nature of Depreciation
A business may spend its capital in two broad ways:
Revenue Expenditure Capital Expenditure
Explanation This is spending on assets that This is spending on fixed assets
are used up in a relatively short that will be used by the business
period of time for a prolonged period of time.
Examples Spending on fuel, components, Expenditure to purchase
and raw materials property, vehicles and
production equipment
Effects on financial statements This type of expenditure is The value of fixed assets
recorded on the profit and loss purchased through capital
account under headings such as expenditure is shown on the
`cost of sales' and `administrative balance sheet. The reduction of
expenses'. It will only affect the value in these assets over time is
accounts in the financial year in listed on the profit and loss
which the expenditure occurs account. This type of expenditure
affects the balance sheet and
profit and loss accounts for a
number of years
Possible effects on profits Revenue expenditure is essential This type of spending has no
to production, but if not immediate effect on profits.
controlled, can have an However, capital expenditure is
immediate and damaging effect essential if a firm is to generate
on a business's profits. longterm profits.
Both types of expenditure are essential for a business's success, but only capital expenditure has any
relevance to the process of depreciation. Depreciation is the reduction of an asset over a period of time.
The amount of the decline in the value (depreciation) will be shown as an expense on the profit and loss
account.
Firms have to depreciate their fixed assets for a number of reasons.
1. To spread the cost of an asset over it's useful life. An assets resale value would decline for a
number of reasons:
Wear and Tear
The production of more modern equipment would mean that the value of this `older'
style equipment would decline.
Poor and inadequate maintenance of the equipment may mean expensive repairs are
necessary.
Thus reducing the value of an asset in line with these factors ensures that the value of the
business recorded on the balance sheet is a relatively accurate indication of the true worth of the
business.
2. Depreciation also allows firms to calculate the true cost of production during any financial year.
Depreciating assets over a few years will lead to a more accurate figure being recorded on the
profit and loss account, helping gain an accurate view of the profitability of the business during
the lifetime of the asset.
Depreciation: a noncash expense
Depreciation is an expense or a cost to a firm that is recorded on the profit and loss account. However,
depreciation is unusual on that it is a noncash expense. Depreciation does not require a business to
make any payment. It is a recognition of the costs of proving a particular expense normally made at the
time the asset is purchased. Depreciation is not a method of providing the cash necessary to replace the
assets at the end of its life.
Reducing Balance Method
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Emma Rudd BMA
The reducing balance method of depreciation lowers the value of a fixed asset by a given percentage
each year. Because the value of the asset is declining over time, this means that the value of which the
asset is reduced declines throughout its life. The key factor determining the reduction in value of an asset
using this approach is the expected life of the asset.…read more

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