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Depreciation Aspects in Accounting - Essay Example

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Explain the way(s) depreciation affects a company’s balance sheet, income statement, and statement of cash flows. Next, tell Kathy whether the…
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Depreciation Aspects in Accounting
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Explain to Kathy the factors that ought to be considered when applying the concept of depreciation to the value of the new server. Explain the way(s)depreciation affects a company’s balance sheet, income statement, and statement of cash flows. Next, tell Kathy whether the straight-depreciation is or is not the right methodology for the server and explain why.
This report analyzes the depreciation methods to be followed and the effects on the company’s statements.
Factors affecting Depreciation:
There are a number of factors to be considered when applying depreciation values to the new server. The most important factors include the usage, units of useful utilities obtained from the asset, the market value of the asset in the future, the rate at which the technology and the hardware becomes obsolete in the segment and in some cases the opportunity costs involved in purchasing the asset. The innovations in Information Technology segments and the accelerated release of upgrades in the computer segment play an important role in analyzing the value of the asset at a particular time period (Samuels et al, 2000). All these factors have to be considered in deciding the appropriate depreciation methodology for the computer server.
Effect of Depreciation:
The depreciation method followed has a great impact on the financial performance of the company. In other terms, the method applied and the values entered in the accounts have a significant effect on the three key financial statements, namely the balance sheet, income statement and the cash flows statement.
The income statement includes the depreciation values incurred in the particular time period and will have a significant effect on the operating profit and the taxes levied. In case the depreciation values are lesser than what was actually incurred, it will give a wrong impression about the company’s performance and can lead to dire circumstances in the later stages.
The fixed assets are represented in the balance sheet. The original cost, accumulated depreciation and the current book values are included so that a clear picture of the usability of the assets is presented. It is imperative to include the appropriate depreciation values so that the book values are close to the market values as possible. In this case, the replacement cost of the assets can be reasonable and will not have any extreme consequences in the performance if the assets are to be replaced. The depreciation values should also clearly indicate the amount of usage that they have been put into, so that the age and usefulness of the fixed assets are clearly depicted (Samuels et al, 2000).
Best Method to be applied:
In the case of the new computer server, it has been estimated that the useful life of the asset is seven years, with no salvage value. It is clear from the current scenario that computer hardware and software become outdated at faster rates than any other product in the market. The depreciation values based on the straight line method are computed and presented in the following section.
It is evident that the yearly deductions will be $ 12,143 which will not reflect the actual case and the company will be paying higher taxes in the early year. Hence straight line depreciation will not be the optimum method to be followed, as it will not reflect or be close to the actual market value of the computer server in the Fixed Assets of the Balance Sheet.
The best suited method to be followed in this case, is the ‘Reducing Balance’ method. The depreciation values in the early years will be very high in this method and it will reduce during the life of the asset. As the scrap value of the computer server is zero, a safe 50% depreciation rate is assumed in the calculations of the Reducing Balance method (Drury, 2005).
Reducing Balance (50%)
Server Value
Book Value
It is evident that the book values derived depict the market values for the computer server, as it declines in its value very rapidly. Hence the company has to utilize the Reducing Balance method to compute the depreciation for the computer server as the financial statements will illustrate the actual performance and also the company will receive tax benefits.
Drury, C., (2005), Management Accounting for Business, 3rd edn., Thomson Learning, London
Samuels, J. M., Wilkes, F. M. and Brayshaw, R. E., 2000, Management of Company Finance, 6th edn, Thomson Learning, London Read More
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