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Depreciation is a fascinating concept in the world of accountancy. When an asset is used, it gradually looses value over a period of time due to wear and tear. For example, in a simple way, there is a difference between price of a new car and a used car. The price of used car is much less than that of the new car. 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”.
Table of Contents
- Depreciation and Accounting
- The Matching Principle
- Fixed Asset
- Understanding the dimensions of depreciation.
Depreciation and Accounting
In accountancy, while depreciation is definitely related to the “decrease in value of an asset”, the process is not that simple. An asset is something that is bought by an enterprise for use in production or service, and not for sale. The enterprise does not purchase the asset with an object to sell that, but to use it in the business process. 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, differentiates the Asset from the Inventory.
The Asset, that we are speaking here is a Capital Asset, while inventory 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.
In contrast, the money spent on purchasing an Asset is not shown as expense of that year’s P/L A/c. This is because of the same two reasons – “object to sell” not there, and “more than one year” of use in business process.
The Matching Principle
There is another concept that is important in understanding the concept of depreciation. This is the concept of “Matching” (or the matching principle). This means that when the profit is to be found out, the basis of profit should be related to the expense incurred in earning that profit. eg. if in a year an enterprise buys raw material of 50 kg (@ Rs. 10), and only 40 kg of that raw material is used in manufacture of that year. The sale revenue being Rs. 700. Then profit would be 700-400=300. The balancing amount for 10 kg that was not used ie. Rs. 100, would be shown as Stock in the Asset side of Balance Sheet.
While it is quite easy to estimate the inventory used in the year, what about the fixed asset, that is being used in the production or manufacturing process. After all, fixed asset is also contributing to the production and earning of revenue of the year.
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 (estimated as) being used up in the year (in production 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 experience, or usual business practice or prescribed by law. 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 P/L A/c.
Understanding the dimensions of depreciation.
Firstly, depreciation can be viewed as a deferred expenditure over the life period of the Asset or as an expense that is amortised over a period of time. However this would not be the right interpretation. Similarly the interpretation that depreciation is a measure of wear-tear is again missing the point. Wear-tear is a general term, more akin to maintenance costs, and not an accounting concept.
Secondly, the amount of depreciation is deductible for tax purposes ie. no tax is levied on that amount of profit that is remaining 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 amount of depreciation that is shown as an expense in the particular financial year, is basically a non-cash expense for that year. ie. in that particular financial year, money does not go out. (it is another matter that the money, a capital expense, has already occured in the year in which the asset was purchased).
Usually the businesses plough back such money and reinvest them into the business operations. In the P&L, the Provision for Depreciation is shown as deduction from Fixed Assets on the Asset side of B/S.
A third point is that Land is not treated as a depreciable item. Land does not depreciate. (Infact, 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.)
A fourth point is that the depreciation provision is not available for distribution to shareholders for dividend purpose. The reason relates to various cases in past when businesses would not deduct depreciation and show an inflated profit. A profit without deducting depreciation would mean a misrepresentation of factual financial position of the entity. This also means that depreciation is neither a reserve that is available to shareholders, nor it is any unrealised gain. Now a days, it is prescribed by law that dividend can be distributed only after deduction of depreciation.
You may also like to read: Accounting Discipline: Easy Conceptual Summary