Depreciation is an accounting method of allocating such cost to expense in a systematic and rational manner to those accounting periods in which the organization is expected to benefit from use of the asset. The core principle of depreciation is allocating rather than tracing. Depreciation accounting requires businesses to report larger expenses during earlier years of an asset’s life and smaller expenses during later years. This process results in expense allocation that reflects the actual wear and tear, or obsolescence, of an asset. In this way, businesses can manage their earnings while abiding by accounting regulations.
There are many benefits associated with using depreciation accounting. First, it allows businesses to better match their expenses with their revenue. This provides a more accurate picture of a company’s financial health. Additionally, it gives businesses a tax deduction for the cost of their assets, which can help reduce their overall tax liability. Finally, it allows businesses to plan for future expenses, such as replacement costs, by setting aside money each year to account for depreciation.
There are several different methods that businesses can use to calculate depreciation expense. The most common method is the straight-line method, which evenly allocates the cost of an asset over its useful life. Other methods include the declining balance method and the sum-of-the-years’-digits method. The accounting method chosen should be based on the specific needs of the business and the type of asset being depreciated.
Depreciation accounting is a critical tool for all businesses. It allows them to better manage their finances, reduce their taxes, and plan for the future. When used correctly, it can provide significant benefits to a company.