Darlisha has a Master of Science degree in Accounting
Michael loves to buy new cars, and almost never drives the same car for more than two years. Currently, he has a 2014 sports car and wants to trade it in for a 2016 sports car. Michael paid $60,000 for his 2014 sports car when he originally purchased it. Upon arriving at the car dealership, Michael finds out that his car is only worth $40,000. This $20,000 decline in value is referred to as accumulated depreciation. The book value of an item is equal to its cost minus accumulated depreciation.
Depreciation and Accumulated Depreciation
Depreciation is defined as the periodic decline in value an item experiences after it has been put to use. Depreciation is normally calculated on a yearly basis. However, some companies calculate depreciation every month. The period of time used to calculate depreciation depends on how often the company prepares its financial statements. For example, if a company prepares its balance sheet and other financial statements at the end of every month, depreciation is calculated on a monthly basis. Accumulated depreciation is the total decline in value over the entire time the item has been used. In Michael's case, the accumulated depreciation on his 2014 sports car is $20,000.
Long-Term vs. Short-Term Assets
On a company's balance sheet, only fixed assets are reported as cost minus any accumulated depreciation. Fixed assets are items that a company intends to use for one year or more. Fixed assets include long-term assets such as machinery and equipment, vehicles, and some furniture. Because these items are long-term assets and thusly, more likely to remain in the company's possession for over a year, it is important that the value of these assets are reported appropriately on the balance sheet. It would be inaccurate for a company to report an asset at its original cost when the asset it purchased, and then the next year report that same asset at the same value it was reported when it was bought. The asset has now been used for a year and is not worth the same amount it was worth before it was used. Short-term assets, such as inventory, do not depreciate because they are normally used or sold within one year. When inventory is purchased, it is normally sold within one year. Therefore, the items are no longer in the company's possession when it is time to prepare its annual financial statements.
Calculating Book Value
The formula to calculate book value is as follows:
|Book Value = Cost - Accumulated Depreciation|
For example, Michael's 2014 sports car cost $60,000 when he purchased it. The total decline in the car's value since it has been driven is $20,000. We would calculate the car's book value as follows:
|Book Value = $60,000 - $20,000|
This explains why Michael's car is now only worth $40,000, which is its book value.
For most items, because their value declines over time, their book value is used to determine their current worth. In business, it is important to know how to calculate book value in order to accurately report the value of certain assets. Reporting the incorrect book value could result in overstating the value of a company's assets, and also overcharging for an item being sold.
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