Depreciation

Question 1

Explain depreciation

Answer 1

The difference between what the value was and what it is now is called depreciation. Depreciation represents the fall in the value of these fixed assets, either due to their use, due to time, or due to obsolescence. The straight-line method of depreciation assumes that a fixed asset depreciates an equal amount to each year of its expected useful life.
Original Cost - Residual Value
Expected life of the asset (years)

Question 2

Why is it important for businesses to depreciate their assets?

Answer 2

• It is essential for businesses to depreciate the value of their machinery, because otherwise the true value would not be reflected.
• Over time machines become worn out and obsolete. If they were valued in the business’ books at their cost price it would give a false picture of their true worth and it would cause the business in general to be overvalued.
• If it was known that the business was window-dressing its accounts in such a way, it would affect the business’ reputation and may affect their ability to borrow money.
• By depreciating the value of their machinery, the business is in a better position to appreciate its real value and hence the need for putting money aside in order to
  purchase replacement machinery in the future.
• There is also a legal requirement to devalue fixed assets in order to reflect their true worth.