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Defining Depreciation

Depreciation can be defined as the Process of systematically allocating capital expenditure incurred over the useful life of the Tangible Non-Current Asset.

Accounting and bookkeeping functions are performed with the intention to produce financial statements and provide different financial reports to the management and stakeholder, so they can make knowledgeable economic and financial decisions. To ensure the actual value addition in the decisions made by its reader, it is very important that these statements and reports shall present a true and fair view. The reported profit and loss shall include all the expenses incurred to earn the revenue for a given period. 

Besides, in Accounting, Matching concept requires that all the expenses incurred to earn the revenue shall be reported in the same period in which the revenue was earned. Based on the same concept any expenditure incurred can be classified into the following two types: –

  • Revenue (Short term) expenditure To earn revenue in the current period, for example, electricity bill paid for electricity used at the office. 
  • Capital (Long term) expenditureExpenses incurred to earn revenues in future periods. For example, lease rentals paid in advance for the next coming years. Although the expense has been paid, we shall not completely charge it against the current period revenues, as the facility of office against which rent has been paid will be consumed in coming years.

Business purchasing plant and machinery or vehicles and any other tangible noncurrent assets are basically making capital expenditures. If these expenses are charged in the same year of its purchase, this may result in turning the whole revenue into losses. This will not reflect the true and fair view of business affairs during the period. It is only appropriate to charge such a portion from the capital expenditure, which actually was utilized to earn revenue. 

For example, XYZ Co. purchased a machine for $100,000 and this machine could produce 1,000,000 units. In the first year of the operation the machine only produced 9,000 units. 

Now what expense shall be charged into the profit and loss of the current period as cost to produce the 9,000 units (from capital expenditure of $100,000)?

  • Since it is apparent that the machine was purchased with the intention to be used for more than a single accounting period, therefore only the portion which was actually utilized shall be expensed out rather than charging the whole $100,000 in the first year.  
  • Further, out of 1,000,000 only 9,000 units were produced, therefore out of total $100,000, only $900 ($100,000/1,000,000 X 9,000) shall be recorded as expense in the first year of operations. Whereas the remaining $99,100 shall be carried forward as Tangible Non-Current Assets (Capital expenditure).

The above illustrated way of allocating the capital expenditure over the economical (useful) life of the asset is called depreciation.

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Need for depreciation

While recording transactions and preparing Financial Statements, one of the key objectives of any accountant is to present a true and fair view of the company affairs. Any traditional Financial Statement shall be consisted of these two basic elements: –

1.       Financial Performance of the Company for a specific period

2.       Financial Position of the Company at any specific time.

1. Financial Performance for a given period

While presenting true and fair performance of the company during a specified period, all expenses incurred to earn the revenue shall be deducted, and realistic profit and loss for the period shall be determined.

Beside what is stated above, Tangible assets are purchased by incurring considerably huge amounts and are not charged as an expense in the year of its purchase, because of the following two reasons.

·         The expense incurred to purchase tangible non-Current assets e.g., Land, Building, Plant and Machinery is usually so huge that charging it in a single period may result into loss and

·         Further, it is not reasonable to charge the whole capital expense in a single period, whereas the economic benefit by utilizing that asset (capital expense) is reaped over many accounting periods.

Instead, the purchase expense of capital nature is deferred and shall spread over the economic life of assets by recording systematic expenses each year till the end of economic life of the asset.

2. Financial Position of the company

True and fair position of the business means that the values for assets, liabilities and the owner equity are accurately presented. These values shall reflect the accurate estimate of the probable in and outflow of future economic benefits of the company.

The value of the assets shown while presenting the financial position of the company shall reflect truthful economic values of the asset. This implies that the value of economic benefits already generated by the business shall be deducted from the value of assets.

For example, a machine was purchased by incurring the expense of $ 100,000. At the time of purchase, it was estimated that this machine will produce 10,000 units of a product before it becomes redundant/ unusable. Now say at the end of 1st year of its operation, the machine produced 1,500 units. This means that the machine has been utilized for the economic value of $ 15,000 ($ 100,000/10,000 X 1,500) till the end of 1st year. Hence at the end of 1st year the estimated economic value shall be $85,000 ($100,000 – $15,000).

Keeping the above example in view, for the fair and truthful presentation of business it is very important that the non-current assets, shall be presented after deducting the economic benefits already have been utilized to generate the revenues. This purpose is achieved by deducting the total depreciation charged for an asset from its cost/ market value.

3. Replacement Cost

The depreciation expense is charged as debit entry into the profit and loss account for a period, whereas the credit of the same amount is recorded in the accumulated depreciation account maintained as provision. The total amount of this provision account is deducted from the cost/ market value of the assets while presenting the carrying value of asset in balance sheet.

Accumulated Depreciation account is maintained as provision, and carries credit balance. Some managers treat this estimated fund against replacement of the asset. This means that the balance of accumulated depreciation accounts at any given time gives an estimate of how much profits have been set aside to replace this asset.

Note: This is a complicated conceptual debate and it is normal if at this stage students do not completely understand it. However, it is important to understand that among other usages, Accumulated Depreciation account is used as an estimation for the replacement fund of the asset.

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Depreciation and Depletion

Depreciation is a representation of use of economic value of an asset. However, when irreplaceable long-term asset such as mines are utilized or have been extracted, this is called depletion.

The value of depletion cannot be restored, whereas if the capital expenditure resulting in increase in useful life may restored.

Depreciation and Amortization

Where the depreciation is the process of systematic allocation of capital expense incurred on tangible assets, Amortization is the process of equal distribution of capital expense incurred to purchase intangible assets e.g., patents rights etc.

While deprecation method applied shall be reflective ow the assets are being used to generate revenues, amortization is charged equally over the useful life of the asset.

Depreciation and Obsolesce

When noncurrent assets are capitalized, its useful life is estimated initially to calculate the depreciation charge for the period. However, this estimate in useful life may decrease subsequently. This decrease in useful life of the asset is called obedience. The most common reasons for obsolesce are Technological advancement, change in market demand, Legal and other restriction and strategic changes within company to improve production processes. 

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Characteristic of Depreciation

· As the depreciation is the systematic allocation of capital expenditures, based on the matching concept of accounting. The Matching concept of accounting involves charging the expenses in the period in which these expenses were incurred to earn the revenue. Therefore, the depreciation method used shall reflect the usage of the Asset. For example, if the useful life of a machine is determined by the number of products it produces, the depreciation for the period shall also be based on the basis of unit produced during the period and shall not be same for each year.

·         All the tangible assets are subject to wear and tear over time. Charging depreciation each year and then showing the value of the asset, after deducting depreciation is reflection of gradual wear and tear due to the use of Asset and true and fair view of the company affairs.

·         As the tangible asset is utilized and gets older, its value decreases over the time. Presenting the asset at depreciated value enables the accountants to reflect the estimated decrease in asset value over the time.

·         Despite some characteristics described above, in essence, depreciation is an expense. It is a spread of capital expenditure (incurred to bring the asset for its intended use) over its useful life, which is charged to profit and loss as debit each year. On the other hand, the credit amount of this accounting entry is kept in the Accumulated depreciation account as a provision and only set-off upon the disposal against the asset.

·         It is very important to understand the depreciation is a non-cash expense and a book adjustment entry only. The actual cash is transacted only either at the time of purchasing asset (capital expenditure) or at the time of disposal. For the period in between assets is used to generate revenue by producing goods by utilizing this asset. The capital expenditure incurred to purchase the assets is allocated against aforementioned revenue in the accounting period by the means of depreciation expense. This allocation of capital expenditure is done by a book adjustment only. However, any expenses incurred for repair and maintenance of the assets are separately recorded under the head of repair and maintenance of the assets.

·         Depreciation is allocation of capital costs incurred on the asset for each year over the useful life. Thus, the depreciation expense is also an indication of how much economic value of the asset has already been utilized and the depreciated value of the asset is the reflection of how much economic value this asset can produce for the company. Such information is critically required when the assets are being sold or the changes in the company strategy requires replacement of tangible non-current assets.

·         The amount of depreciation reflects the decrease in economic value of the asset, however an important point to remember is that this depreciated amount is not the market value of the asset. The Actual market value may considerably different from the depreciated vale being represented in balance sheet. The main reason for the difference is the depreciated value in Balance Sheet is COST less accumulated depreciation, whereas the current value of the asset might have changed since the asset was purchased e.g., Currency Exchange rate might have changed since the asset was purchased resulting change in market value of the asset.

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