What is depreciation in accounting?
Let’s explain the process to you in detail today.
Depreciation is a key idea in accounting and finance that helps businesses manage the cost of their big purchases, like machines and buildings, over time.
Depreciation is a critical concept in the world of:
- Finance,
- Accounting, &
- Business operations
Understanding depreciation is essential for keeping:
- Accurate financial records
- Making smart financial decisions
- Getting tax benefits.
In this article, you will learn:
- What is depreciation in accounting?
- What is its significance?
- Is depreciation a debit or credit?
- How do companies calculate it?
What is Depreciation in Accounting?
Depreciation is the systematic allocation of the cost of a tangible asset over its useful life.
It’s a way to spread out the cost of something expensive, like machinery or equipment, over the time you use it.
Instead of recording the full cost of these items when they buy them, companies spread out the expense over the years they use them.
This way, the cost matches the income the equipment generates each year.
It accounts for the reduction in value that an asset experiences as it is used in a company’s operations.
When a company uses an asset like machinery or equipment, it doesn’t stay in perfect condition forever. Over time, it gets used up, wears out, or becomes outdated.
Depreciation is a non-cash expense because it doesn’t involve spending actual money when you record it. Instead, it’s an accounting method to spread the cost of an asset over its useful life.
Even though no cash is spent when recording depreciation, it’s crucial for financial reporting because it:
- Shows the true cost of using an asset over time.
- Ensures expenses are recorded in the same period as the revenue is generated, providing a more accurate picture of profitability.
- Lowers the taxable income since depreciation is considered an expense.
Let’s understand this with an example:
Let’s say, you buy a machine for Rs 10,00,000 and you expect to use it for 10 years:
- Instead of recording the Rs 10,00,oo0 as an expense all at once, you record Rs 1,00,000 each year as depreciation.
- Each year, you show that the machine is losing Rs 1,00,000 in value due to use, wear, and tear.
- This Rs 1,00,000 is recorded as an expense on the income statement (reducing profits) but doesn’t involve paying out Rs 1,00,000 in cash each year. The cash outflow happened when you bought the machine.
Depreciation spreads the cost of an asset over its useful life, showing its wear and tear, and is recorded as an expense without involving actual cash flow, making it essential for accurate financial reporting.
Is Depreciation a Debit or Credit?
Depreciation is not directly classified as either a debit or a credit. Instead, in accounting, depreciation involves two specific entries:
- Depreciation Expense: This is a Debit account, it shows the cost of using the asset.
- Accumulated Depreciation: This is a contra-asset or Credit account, it shows the total amount of value the asset has lost.
Here’s how it works:
You make two entries in your accounting records:
- Depreciation Expense: This shows up as a cost on your income statement, it’s a debit entry. Think of it like noting down the used-up part of the asset’s value.
- Accumulated Depreciation: This shows up on your balance sheet, it’s a credit entry. This is where you keep track of all the depreciation that’s been recorded over time.
Let’s say you have a piece of equipment that depreciates by Rs 1,00,000 this year.
You would record it like this:
- Debit Depreciation Expense: Rs 1,00,000
This means you’re saying, “We used up Rs 1,00,000 worth of this equipment’s value.”
- Credit Accumulated Depreciation: Rs 1,00,000
This means you’re adding Rs 1,00,000 to the total amount of depreciation you’ve recorded for this equipment over time.
Therefore, while depreciation itself is neither a debit nor a credit, it results in a debit entry (Depreciation Expense) on the income statement and a corresponding credit entry (Accumulated Depreciation) on the balance sheet.
This process shows the true value of your assets and the cost of using them over time.
How to Calculate Depreciation in Accounting?
There are several methods to calculate depreciation, the most common being the straight-line method, which spreads the asset’s cost evenly over its useful life.
The formula for straight-line depreciation is:
Depreciation Expense = (Cost of Asset – Salvage Value) / Useful Life
For instance, let’s look at a relevant example to understand how depreciation is calculated in an Indian-listed company.
Tata Motors, a major car manufacturer in India, uses depreciation to spread out the cost of its equipment, vehicles, and other assets over their useful life.
Calculation of depreciation:
1. Cost of Asset: Suppose Tata Motors buys a piece of equipment for ₹10,00,000.
2. Salvage Value: This is what the equipment is expected to be worth at the end of its useful life. Let’s say it’s ₹1,00,000.
3. Life: This is the number of years Tata Motors expects to use the equipment. Assume it’s 9 years.
Using the formula:
Depreciation Expense= ₹10,00,000 – ₹1,00,000 / 9 = 9,00,000 / 9 = 1,00,000
Therefore, each year, Tata Motors will record ₹1,00,000 as the depreciation expense for this equipment.
This means every year, ₹1,00,000 of the equipment’s cost is considered an expense on Tata Motors’ financial statements.
By doing this, Tata Motors shows how the equipment’s value decreases over time, giving a more accurate picture of the asset’s current value and the company’s overall financial health.
Manipulation of Depreciation in Accounting
While depreciation is a fundamental accounting concept, companies can potentially manipulate it to influence their financial statements.
Some methods of manipulation include:
- Changing Useful Life Estimates: Companies can change the estimated useful life of their assets, which impacts the annual depreciation expense. A longer useful life reduces annual depreciation.
- Accelerated Depreciation: Some companies may use accelerated depreciation methods, which front-load depreciation expenses, leading to higher expenses in the early years of an asset’s life.
- Asset Impairment: Writing down the value of assets can significantly affect depreciation expenses and asset values on the balance sheet.
Stakeholders should be aware of these potential manipulations and consider them when evaluating a company’s financial statements.
Manipulation of depreciation in accounting is generally considered bad practice and is not advised.
It’s generally unethical and harmful as it can lead to serious legal, financial and reputational consequences.
An accurate and honest financial report helps in:
- Maintaining trust
- Making informed decisions
- Ensuring the long-term success of a company.
Depreciation adjustments should be based on genuine changes in circumstances and should be transparently disclosed to stakeholders.
Conclusion
Depreciation is an integral aspect of financial reporting and analysis, allowing companies to accurately represent the reduced value of their assets over time.
It’s not about spending cash right away but about recording the cost of using assets gradually.
Is depreciation a debit or credit?
It isn’t directly a credit or debit, however, it does affect financial statements significantly.
Depreciation expense is a debit on the income statement, showing how much value assets have lost. Meanwhile, accumulated depreciation, a credit on the balance sheet, adds up all the depreciation recorded over time.
This methodical way of recording helps businesses calculate metrics like net income and asset values accurately.
Stakeholders need to understand because it reveals how well a company manages its resources and reports its financial health.
