What Is a Depreciation Allowance?
Companies all over the world allow for depreciation on their assets. This is essential, as the value of the assets tends to diminish over time due to usage. When the company has a depreciation allowance in place, it is able to ward off the losses it would have incurred when the asset actually stops functioning. Every year, the company depreciates the asset and then transfers the money to the depreciation allowance. Each year, money keeps accruing in the account until the end of the asset's productive life.
Every year, the company reduces the value of the asset as per the depreciation method it chose at the time the asset was bought. The methods chosen could be "the straight line method," "the written-down value method," "the sum-of-years method" or "the double-declining method." The sum reduced from the asset's value is added to the deprecation allowance account. The money keeps accumulating there until the asset becomes obsolete and can no longer be used.
The money collected in the account enables the purchase of a new asset when the old one can longer be used. Each asset of the company has its own depreciation and allowance for depreciation accounts. The depreciation allowance account is also referred to as the "accumulated depreciation account." This account contains the sum total of the entire amount that has already been written off on the asset. The asset's value contained in the company's balance sheet is the price for which the asset was purchased minus the depreciation allowance until date.
The depreciation allowance account usually does not appear on the company's balance sheet. The value of every asset is shown as its "Net Value." The net value of the asset is the value of the asset at the beginning of the year from which the depreciation amount for this year has been deducted. The depreciation allowance account is shown in the company's annual reports and not on its balance sheet.
By using depreciation allowance, the company at all times is able to project a true picture of its finances. The assets are neither over-priced nor under-priced owing to the depreciation allowance. Also, the company is able to enjoy tax benefits due to depreciation allowance. The government does not charge taxes on the depreciation that companies provide on their assets. The money saved by the company is either paid to its shareholders as dividends or put back into the company for further expansion.