Why depreciation is a Non Cash Expense?, Why Reserve Maintained for Depreciation ? , Why Depreciation expense needs to be added back to Net Income in Cash Flow.
Definition of Depreciation:
Definition of Depreciation:
Financial Reporting Standard 15 (covering the accounting for tangible fixed assets) defines depreciation as follows:
"The wearing out, using up, or other reduction in the useful economic life of a tangible fixed asset whether arising from use, effluxion of time or obsolescence through either changes in technology or demand for goods and services produced by the asset.'
A portion of the benefits of the fixed asset will be used up or consumed in each accounting period of its life in order to generate revenue. To calculate profit for a period, it is necessary to match expenses with the revenues they help earn.
In determining the expenses for a period, it is therefore important to include an amount to represent the consumption of fixed assets during that period (that is, depreciation).
In essence, depreciation involves allocating the cost of the fixed asset (less any residual value) over its useful life. To calculate the depreciation charge for an accounting period, the following factors are relevant:
- the cost of the fixed asset;
- the (estimated) useful life of the asset;
- the (estimated) residual value of the asset.
What is the relevant cost of a fixed asset?
The cost of a fixed asset includes all amounts incurred to acquire the asset and any amounts that can be directly attributable to bringing the asset into working condition.
Directly attributable costs may include:
- Delivery costs
- Costs associated with acquiring the asset such as stamp duty and import duties
- Costs of preparing the site for installation of the asset
- Professional fees, such as legal fees and architects' fees
Note that general overhead costs or administration costs would not be included as part of the total costs of a fixed asset (e.g. the costs of the factory building in which the asset is kept, or the cost of the maintenance team who keep the asset in good working condition)
The cost of subsequent expenditure on a fixed asset will be added to the cost of the asset provided that this expenditure enhances the benefits of the fixed asset or restores any benefits consumed.
This means that major improvements or a major overhaul may be capitalised and included as part of the cost of the asset in the accounts.
However, the costs of repairs or overhauls that are carried out simply to maintain existing performance will be treated as expenses of the accounting period in which the work is done, and charged in full as an expense in that period.
What is the Useful Life of a fixed asset?
An asset may be seen as having a physical life and an economic life.
Most fixed assets suffer physical deterioration through usage and the passage of time. Although care and maintenance may succeed in extending the physical life of an asset, typically it will, eventually, reach a condition where the benefits have been exhausted.
However, a business may not wish to keep an asset until the end of its physical life. There may be a point when it becomes uneconomic to continue to use the asset even though there is still some physical life left.
The economic life of the asset will be determined by such factors as technological progress and changes in demand. For purposes of calculating depreciation, it is the estimated economic life rather than the potential physical life of the fixed asset that is used.
What about the Residual Value of a fixed asset?
At the end of the useful life of a fixed asset the business will dispose of it and any amounts received from the disposal will represent its residual value. This, again, may be difficult to estimate in practice. However, an estimate has to be made. If it is unlikely to be a significant amount, a residual value of zero will be assumed.
The cost of a fixed asset less its estimated residual value represents the total amount to be depreciated over its estimated useful life.
Depreciation of fixed assets :Introduction
In our introduction to accounting for fixed assets, we described how businesses need to account for the consumption of fixed assets over time in a way that reflects their reducing value. The term given to this consumption is depreciation. This revision note explains the various methods available to calculate depreciation and highlights how subjective this calculation can be. Other revision notes provide worked example of each depreciation method.
Depreciation Methods :
The total amount to be depreciated over the life of a fixed asset is determined by the following calculation:
Cost of the fixed asset less residual value
The period over which to depreciate a fixed asset is known as the "useful economic life" of the asset.
So how much of this depreciable amount is charged against profits in each accounting period?
A depreciation method is required to allocate, in a systematic way, the total amount to be depreciated between each accounting period of the asset's useful economic life.
There are various methods of depreciation available. However, most businesses appear to adopt one of the two methods described below.
Method 1 - Straight-line depreciation:
The straight-line method of depreciation is widely used and simple to calculate. It is based on the principle that each accounting period of the asset's life should bear an equal amount of depreciation.
As a result, the depreciation charge for the asset can be calculated using the following formula:
Dpn = (C- R)/ N
Dpn = Annual straight-line depreciation charge
C = Cost of the asset
R = Residual value of the asset
N = Useful economic life of the asset (years)
Whilst it is simple and popular, Is the straight line depreciation method the most appropriate way of calculating depreciation?
The answer lies in understanding that depreciation is a process of allocation, not valuation.
The pattern of annual depreciation charges for a fixed asset should attempt to match the pattern of benefits derived from that asset. Therefore, where the benefits from an asset are likely to be reasonably constant over its life the straight-line method of depreciation would be appropriate as it results in a constant annual depreciation charge.
In practice it may be difficult to assess the pattern of benefits relating to an asset. In such cases the straight-line method may often be chosen simply because it is easy to understand and calculate.
Method 2 - Reducing balance method:
The reducing balance method of depreciation provides a high annual depreciation charge in the early years of an asset's life but the annual depreciation charge reduces progressively as the asset ages.
To achieve this pattern of depreciation, a fixed annual depreciation percentage is applied to the written-down value of the asset. Thus, depreciation is calculated as a percentage of the reducing balance.
For certain fixed assets, the benefits derived may be high in the early years, but may decline as the asset ages. For such assets, the reducing-balance method of depreciation would be appropriate insofar as it matches the depreciation expense with the pattern of benefits.
Once a particular method of depreciation has been chosen for a fixed asset, the method should be applied consistently over its life. It is only permissible to switch from one method to another if the new method provides a fairer presentation of the financial results and financial position.
Total depreciation charged
It should be noted that, whichever method of depreciation is selected, the total depreciation to be charged over the useful life of a fixed asset will be the same.
It is simply the allocation of the total depreciation charge between accounting periods that is affected by the choice of method.
The need for provision for depreciation arises for the following reasons:
(1) Ascertainment of true profit or loss-Depreciation is a loss. So unless it is considered like all other expenses and losses, true profit/loss cannot be ascertained. In other words, depreciation must be considered in order to find out true profit/loss of a business.
(2) Ascertainment of true cost of production-Goods are produced with the help of plant and machinery which incurs depreciation in the process of production. This depreciation must be considered as a part of the cost of production of goods. Otherwise, the cost of production would be shown less than the true cost.
price is normally fixed on the basis of cost of production. So, if the cost of production is shown less by ignoring depreciation, the sale price will also be fixed at a low level resulting in loss to the business; Sale
(3) True Valuation of Assets-Value of assets gradually decreases on account of depreciation. If depreciation is not taken into account, the value of asset will be shown in the books at a figure higher than its true value and hence the true financial position of the business will not be disclosed through Balance Sheet.
(4) Replacement of Assets-After some time an asset will be completely exhausted on account of use. A new asset then be purchased requiring large sum of money. If the whole amount of profit is withdrawn from business each year without considering the loss on account of depreciation, necessary sum may not be available for. buying the new assets. In such a case the required money is to be collected by introducing fresh capital or by obtaining loan by selling some other assets. This is contrary &0sound commercial policy.
(5) Keeping Capital' Intact-Capital invested in buying an asset, gradually diminishes on account of depreciation. If loss on account of depreciation is not considered in determining profit/ loss at the year end, profit will be shown more. If the excess profit is withdrawn, the working capital will gradually reduce, the business will become weak and its profit earning capacity will also fall.
(6) Legal Restriction-According to Sec. 205 of the Companies Act, 1956 dividend cannot be declared without charging depreciation on fixed assets. Thus in "Case of joint stock companies charging of depreciation is compulsory.
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Why Depreciation Expense needs to be added back to Net Income in Cash Flow ?
Depreciation moves the cost of an asset to Depreciation Expense during the asset's useful life. The accounts involved in recording depreciation are Depreciation Expense and Accumulated Depreciation. As you can see, cash is not involved. In other words, depreciation reduces net income on the income statement, but it does not reduce the Cash account on the balance sheet.
Because we begin preparing the statement of cash flows using the net income figure taken from the income statement, we need to adjust the net income figure so that it is not reduced by Depreciation Expense. To do this, we add back the amount of the Depreciation Expense.
Depletion Expense and Amortization Expense are accounts similar to Depreciation Expense, as all three involve allocating the cost of a long-term asset to an expense over the useful life of the asset. There is no cash involved.
Let's illustrate how a depreciation expense is handled by continuing with the Good Deal Co.
June Transactions and Financial Statements:
The only transaction recorded by Good Deal during June was the depreciation on the office equipment. Recall that on May 31 Good Deal purchased the office equipment (a new computer and printer) for $1,100 and it was put into service on the same day. Let's assume that a depreciation expense of $20 per month is recorded by Good Deal. As a result, Good Deal's financial statements at June 30 will be as follows:
A balance sheet comparing June 30 to May 31 and the resulting differences or changes is shown below:
The cash flow statement for the month of June illustrates why depreciation expense needs to be added back to net income. Good Deal did not spend any cash in June, however, the entry in the Depreciation Expense account resulted in a net loss on the income statement. To convert the bottom line of the income statement (a loss of $20) to the amount of cash provided or used in operating activities ($0) we need to add back or remove the depreciation expense amount.
Let's review the cash flow statement for the six months ended June 30:
- The operating activities section starts with the net income of $280 for the six-month period. Depreciation expense is added back to net income because it was a noncash transaction (net income was reduced, but there was no cash spent on depreciation). The increase in the Inventory account is not good for cash, as shown by the negative $200. Similarly, the increase in Supplies is not good for cash and it is reported as a negative $150. Combining the amounts, the net change in cash that is explained by operating activities is a negative $50.
- The increase in long-term assets caused a cash outflow of $1,100 which is reported in the investing activities section.
- There were no changes in long-term liabilities. There was a change in owner's equity since December 31, and as a result the financing activities section reports the owner's $2,000 investment into the Good Deal Co.
- Combining the operating, investing, and financing activities, the statement of cash flows reports an increase in cash of $850. This agrees with the change in the Cash account as shown on the balance sheets from December 31, 2011 and June 30, 2012.