Cash Flow Analysis and Other Factors

Depreciation

Depreciation refers to two very different but related concepts: the decrease in value of assets (fair value depreciation), and the allocation of the cost of assets to periods in which the assets are used (depreciation with the matching principle).

Fair Value Depreciation

Fair value depreciation affects the values of businesses and entities. It is a concept used in accounting and economics, defined as a rational and unbiased estimate of the potential market price of a good, service, or asset, considering the amount at which the asset could be bought or sold in a current transaction between willing parties.

Allocation of Cost with Matching Principle

Depreciated value Depreciation measures how much of an asset is used up in a certain amount of time.

The allocation of an asset's cost to periods in which it is used up affects net income. Any business or income-producing activity using tangible assets incurs costs related to those assets. In determining the net income from an activity, the receipts from the activity must be reduced by appropriate costs.

One such cost is the cost of assets used but not currently consumed in the activity. Such costs must be allocated to the period of use. Where the assets produce benefits in future periods, the matching principle of accrual accounting dictates that those costs must be deferred rather than treated as a current expense.

The business records depreciation expense as allocating such costs for financial reporting. The costs are allocated rationally and systematically as depreciation expenses for each period the asset is used, beginning when the asset is placed in service.

Generally, this involves four criteria:

1. The cost of the asset.
   
   
2. The expected salvage value, also known as the residual value of the asset.
   
   
3. The estimated useful life of the asset.
   
   
4. A method of apportioning the cost of such life.

The cost of an asset so allocated is the difference between the amount paid for it and its salvage value.

Methods

Depreciation is any method of allocating net cost to those periods expected to benefit from asset use. Generally, the cost is allocated as a depreciation expense among the periods in which the asset is expected to be used. Such expense is recognized by businesses for financial reporting and tax purposes. Methods of computing depreciation may vary by asset for the same business. Methods may be specified in the accounting or tax rules of a country. Several standard methods of computing depreciation expense may be used, including:

• fixed percentage
  
  
• straight line
  
  
• declining balance method

Depreciation expense generally begins when the asset is placed in service. For instance, a depreciation expense of $100 per year for 5 years may be recognized for an asset costing $500.