Depreciation is the reduction in the value of an asset due to :
- normal wear and tear
- effluxion (passage) of time
Depreciation can be used both in the practical sense and in accounting sense. In practical sense the reduction happens in the market value of an asset you own like mobile phone, laptop, car, furniture, washing machine, TV, etc. whose value reduces as these assets grow old.
In accounting sense it means the reduction in the book value of the asset due to factors mentioned above. In this article we are dealing with meaning of depreciation in accounting sense.
Capital expenditure and Revenue Expenditure
Revenue expenditure is an expense which gives benefits for a small period of time usually an year. Such expenses are charged off to the profit and loss A/c in the same year in which these are incurred. Examples – Salary, Rent, electricity expenses, freight, insurance, etc.
On the other hand capital expenditure is incurred on purchasing assets which gives benefits for a longer period usually more than a year. Such expenses are not charged to the profit and loss A/c fully in the same year in which these are incurred but instead these are carried forward to the next years till its useful life. Examples – Machinery, Building, Furniture, Vehicles, etc.
Here it is pertinent to note that all expenditure whether revenue or capital should end up in the profit and loss A/c. Revenue expenditure is charged to profit and loss A/c fully in the same year. But capital expenditure in charged to profit and loss A/c over multiple years over its useful life. The amount to be charged each year is calculated by following some rational basis which reflect the actual usage of the asset in the real life. The amount which is charged to profit and loss A/c each year from a capital expenditure is known as depreciation.
So depreciation is a non cash expense for the business entity and is transferred to the debit side of profit and loss A/c :
- to determine correct profit or loss for the year (understand some part of asset is getting used each year and should be taken to profit and loss A/c to comply with matching principle)
- to show true and fair view of the financial position of the entity in the Balance sheet by reducing some part of asset every year which closely reflects its actual usage in real life
Why depreciation is a non cash expense
When an asset is purchased for the first time then the actual cash flow happens in the first year and the asset is taken to Balance Sheet. In all the subsequent years when depreciation is charged it is only a book entry to reduce the book value of the asset. So depreciation is a non cash expense
Is depreciation charged on all assets
Depreciation is charged on all assets except freehold land. It is due to the fact that land has infinite life whereas the other assets have a finite life
Characteristics of Depreciation
- It is provided every year
- It is an expense over its estimated useful life
- It is a non cash expense
- It is an indirect expense and is taken to profit and loss A/c and not to the trading A/c
- Since it is an indirect expense so it is not considered while calculating gross profit
- It is debited to profit and loss A/c
- Its nature is nominal A/c
Similar sounding terms
Depreciation – As explained above. This term is used in the context of tangible assets i.e. those assets which can be seen or touched. Examples – Machinery, Building, Vehicles, etc.
Amortization – It is similar to depreciation. Only difference is that it is used in the context of intangible assets. Examples – patents, copyrights, mastheads, brands, software, etc.
Depletion – It is similar to depreciation. Only difference is that it is used in the context of wasting assets like mines and quarries. Example – Extraction of coal or iron ore from its mines will reduce the content in mine to that extent. This value extracted is charged every year as depletion and is similar to depreciation.