The Concept of Depreciation

Understanding depreciation

Initially, should be understood that depreciation is a fascinating concept in the world of accountancy. Ordinarily it is
meant as, a “decrease in price or value over time", or “decrease in value of an asset due to obsolescence or use". In
accountancy, while depreciation is definitely related to the “moderate in value of an asset", the process is not that
simple. An asset is something that is bought by a project for use in production or service, and not for sale. The
business enterprise does not purchase the asset with an objective to sell that, but to use it in the business progression.
Moreover, the time period of use of such asset is more than one year. Both these thing- “object to sell” not there, and
“more than one year” of use in business process, differentiate the Asset from the provided. The Asset, which in
question is the, is a Capital Asset, while stock is a Current Asset. The money spent on inventory is expensed in the
very year in which they are bought - meaning, such money is shown as an expense in the Profit & Loss A/c of that
year. In contrast, the money spent on purchase of a capital asset continues as a balance in the Balance Sheet for
certain number of years or more specifically, till the capital asset has any economic value for the business entity.

There is another concept that is important in understanding the concept of depreciation. This is the concept of
“Matching” (or the corresponding principle). This principle refers to that when the earnings is to be create out, the
basis of profit should be related to the expense incurred in earning that profit.

The effect of depreciation

While it is quite easy to approximation the stock used in the year, what I think about the fixed asset as that which is
used in the produce or manufacturing process of goods. After all, fixed asset is also contributing to the production
and earning of revenue of the year. Importantly, no depreciation deduction is allowed for inventories or other
property held for sale to customers in the ordinary course of business.

Now, this element of fixed asset that is being used up in production process is also entering as a cost for the revenue
that is being earned. This element of fixed asset that is being used up in the year (in invention for generating
revenue) is called depreciation. It is an estimate because what is being used up is not visible to the eyes.

These estimates are primarily based on understanding or usual business practice or prescribed by law in the
accounting regulation. The two most used methods are the Straight Line Method (SLM) and the Written down Value
(WDV). I would not go into the details of these here, except for saying that the amount of depreciation for the year
is taken as an expense in the year’s second year.

A few related dimensions of depreciation require understanding.

Firstly, depreciation can be viewed as a deferred expenditure over the life time of the Asset or as an expenditure that
is amortized greater than a period of time. Similarly the understanding that depreciation is a measure of wear-tear is
again misplaced the point. Wear-tear is a general term, more of the same kind to continuation costs, and not an
accounting concept.

Secondly, the amount of depreciation is deductible for tax purpose i.e. no tax is levy on that amount of profit that is
outstanding with the business as depreciation. This means that it is the amount of profit that is remaining with the
business (that has already been expensed in the year in which the asset was bought) in the current year. The quantity
of depreciation that is shown as an expense in the particular monetary year is mainly a non-cash expense for that
year. I.e. in that particular financial year, money does not go out. (It is another matter that the money, a capital
outflow, has already occurred in the year in which the asset was purchased). Usually the businesses plough back
such money and put into them into the business operation. In the balance sheet, the Provision for Depreciation is
shown as deduction from Fixed Assets total on the Asset side of balance sheet. Technically; these are not considered
"tax reductions" but tax deferrals: because lowering taxable income now by increasing expenses should increase
future taxable income (and taxes) at a later date.

A third point is that Land is not treated as a depreciable item. Land does not depreciate. In fact, the value of land
only increases on revaluation, if any. Though, in accounts, land is usually carried at cost of purchase till some
compelling reason is there for revaluation. . Land is also not depreciable; however, improvements to land are usually
depreciable, including landscaping.

A fourth point is that the depreciation condition is not available for allocation to shareholders for dividend purpose.
The reason relates to a variety of cases in past when businesses would not take away depreciation and show an
overstated profit. A profit without deducting depreciation would mean a distortion of factual financial position of the
company. This also means that depreciation is neither a hold back that is available to shareholders, nor it is any
unrealized gain. Now a days, it is prescribed by law that dividend can be distributed only after deduction of
depreciation.

In accounting, depreciation is a term used to describe any method of attributing the historical or purchase cost of an
asset, across its useful life, roughly corresponding to normal wear and tear. It is of most use when dealing with
assets of a short, fixed service life, and which is an example of applying the matching principle as per generally
accepted accounting principles (GAAP). Depreciation in accounting is often mistakenly seen as a basis for
recognizing impairment of an asset, but unexpected changes in value, was seen as significant enough to account for,
and is handled through write-downs or similar techniques which adjust the book value of the asset to reflect its
current value. Therefore, it is important to recognize that depreciation, when used as a technical accounting term, is
the allocation of the historical cost of an asset across time periods when the asset is employed to generate revenues.
This process of cost allocation has little or no direct relationship to the market value or current selling price of the
asset, it is simply the recognition that a portion of the asset's cost. The use of depreciation affects the financial
statements and i n some countries the taxes of companies and individuals. The recording of depreciation will cause
all the expenses to be recognized, thereby lowering stated profits on the income statement of the company, while the
net value of the asset will decline on the balance sheet. Depreciation and its related concept, amortization (generally,
the depreciation of intangible assets), are non-cash expenses. Neither depreciation nor amortization will directly
influence the cash flow of a company, as both are accounting representations of expenses attributed to a given
period. In accounting statements, depreciation maybe neither figure in the cash flow statement, or may be "added
back" to net income to derive the operating cash flow. Depreciation recognized for tax purposes will, however,
affect the cash flow of the company, as tax depreciation will reduce taxable profits; there is generally no requirement
that treatment of depreciation for tax and accounting purposes be identical. Where depreciation is shown on
accounting statements, the figure usually does not relate to depreciation for tax purposes.

Furthermore, Salvage value is the estimated value of the asset at the end of its useful life. In this way, total
depreciation for an asset will never exceed the estimated total cash outlay on the basis depreciable concepts for the
asset. The exception to this is in many price-regulated industries where salvage is estimated net of the cost of
physically removing the asset from service. If the expected cost of removal exceeds the expected raw (or gross)
salvage, then the net of the two (called Net Salvage) may be negative. In this case, the depreciation recorded on the
regulated books may exceed the depreciable basis. A company has no obligation to dispose of depreciated assets, of
course, and many fully depreciated assets continue to generate income.

Recording a depreciation expense will involve a credit to an accumulated depreciation account. So the
corresponding debit will involve either an expense account or an asset account which represents a future expense,
such as work in process. Depreciation is recorded as an adjusting journal entry.

There are several methods for calculating depreciation,

Straight-line depreciation

Straight-line depreciation is the simplest and most often used technique, in which the company estimates the Salvage
Value of the asset after the length of time over which it will be used to generate revenues (useful life), and will
expense a portion of original cost in equal increments over that amount of time. The Salvage Value is an estimate of
the value of the asset at the time it will be sold or disposed of; it may be zero Straight-Line Method:

For example, a vehicle that depreciates over 5 years, is purchased at a cost of k17, 000 000, and will have a Salvage
Value of K2000000, will depreciate at K3, 000 000 per year: (K17, 000 000 - K2, 000 000)/ 5 years = K3, 000 000
annual straight-line Depreciation Expense. In other words, it is the Depreciable Cost of the asset divided by number
of years of its useful life.
This table illustrates the straight-line method of depreciation. Book Value at the beginning of the first year of
depreciation is the Original Cost of the asset. At any time Book Value equals Original Cost minus Accumulated
Depreciation.

Book Value = Original Cost - Accumulated Depreciation

Book Value at the end of year becomes Book Value at the beginning of next year. In addition, this gain above the
depreciated value would be recognized as ordinary income by the tax office. If a company chooses to depreciate an
asset at a different rate from that used by the tax office then this generates a timing difference in the income
statement due to the difference between the taxation department's and company's view of the profit.

Declining-Balance Method

Depreciation methods that provide for a higher depreciation charge in the first year of an asset's life and gradually
decreasing charges in subsequent years are called accelerated depreciation methods. This may be a more realistic
reflection of an asset's actual expected benefit from the use of the asset: many assets are most useful when they are
new. One popular accelerated method is the declining-balance method. Under this method the Book Value is
multiplied by a fixed rate.

Annual Depreciation = Depreciation Rate * Book Value at Beginning of Year

The most common rate used is double the straight-line rate. For this reason, this technique is referred to as the
double-declining-balance method. To illustrate, let's use the following example. Suppose, with double-declining-
balance method, as the name suggests, double that rate, or 40% depreciation rate is used.

MISCONCEPTIONS ABOUT DEPRECIATION

Since depreciation is an allowance of cost over accounting period, it is not directly connected to promote value—or
the quantity that the asset would be worth if it was sold. The order value of an asset, computed as the actual cost
minus the accumulated depreciation, is simply the unallocated cost of the item. The pattern of depreciation is fixed,
and does not respond to changing market conditions.

Depreciation does not involve any cash flow. This is clearest in the simple case of an asset acquired entirely by cash
payment. Although the initial purchase is a cash flow, the subsequent allocation of part of the cost as a period
expense involves only an accounting entry. Depreciation is not intended as a mechanism to provide for replacement
of the asset. There are no cash flows associated with depreciation, and there is no connection with any cash
accumulated for replacement of the asset. The asset may or may not be replaced this is a capital budgeting decision
that is immaterial to the recognition of expense.

Because depreciation is an expense but has no associated cash flow, it is sometimes described as being "added back"
to arrive at cash flow for the firm. This gives the impression that depreciation is somehow a source of cash flow. The
"adding back," however, is simply recognition that no cash flow occurred, and depreciation cannot supply cash.
Reference

Baxter, William. "Depreciation and Interest." Accountancy. October 2000.

Bernstein, L.A. Financial Statement Analysis: Theory, Application and Interpretation. Irwin, 1989.

Cummings, Jack. "Depreciation Is Out of Favor, But It Matters." Triangle Business Journal. February 25, 2000.

Harrison, Jr., W.T., and C.T. Horngren. Financial Accounting. Prentice Hall, 1995.

Marullo, Gloria Gibbs. "Catching Up on Depreciation." Nation's Business. October 1996.