Depreciation Logic

mr. Mohit as we charged dep in p&l a/c our profit get reduce and value of assets also get reduce.. At the same time u r booking dep as exp but there is u r not paying single penny for that expenditure so u have cash balance in hand now u can invest that cash in some account and this way over the period of time u will be able to accumulate more some of money.. So when u need to purchase new assets u can use that accumulated money... Hope u get it clear...

Originally posted by : CA Ashsih Jaiswal
	mr. Mohit as we charged dep in p&l a/c our profit get reduce and value of assets also get reduce.. At the same time u r booking dep as exp but there is u r not paying single penny for that expenditure so u have cash balance in hand now u can invest that cash in some account and this way over the period of time u will be able to accumulate more some of money.. So when u need to purchase new assets u can use that accumulated money... Hope u get it clear...

very clear...................

awesome reply............................................

AS  U KNOW MOHIT , DEPRESSION IS A NON CASH ITEM . IN P&L ACCOUNT WE SHOW IT AS A EXPENSE AND WHICH REDUCE THE PROFITS BUT AS THIS IS NON CASH EXPENSE NO CASH GET REDUCE THATS HOW WE BLOCK SUCH AMOUNT OF CASH BY PROVIDING DEPRESSION ,  AS YEAR PASSES WE COLLECT A GOOD MONEY AND THEN WE CAN USE THIS MONEY IN REPLACING THE ASSEST . YOU CAN RELATE IT TO  CASH FLOW STATEMENT WHERE WE TREAT DEPRESSION AS A NON CASH EXPENSE . HOPE U GET THE CONCEPT NOW .

For accounting purposes, depreciation indicates how much of an asset’s value has been used up. For tax purposes, businesses can deduct the cost of the tangible assets they purchase as business expenses; however, businesses must depreciate these assets in accordance with IRS rules about how and when the deduction may be taken based on what the asset is and how long it will last.

Depreciation is used in accounting to try to match the expense of an asset to the income that the asset helps the company earn. For example, if a company buys a piece of equipment for $1 million and expects it to have a useful life of 10 years, it will be depreciated over 10 years. Every accounting year, the company will expense $100,000 (assuming straight-line depreciation), which will be matched with the money that the equipment helps to make each year. 

 

What Is Depreciation? 
Depreciation is the process by which a company allocates an asset's cost over the duration of its useful life. Each time a company prepares its financial statements, it records a depreciation expense to allocate a portion of the cost of the buildings, machines or equipment it has purchased to the current fiscal year. The purpose of recording depreciation as an expense is to spread the initial price of the asset over its useful life. For intangible assets - such as brands and intellectual property - this process of allocating costs over time is called amortization. For natural resources - such as minerals, timber and oil reserves - it's called depletion. 

Assumptions 
Critical assumptions about expensing depreciation are left to the company's management. Management makes the call on the following things:

• Method and rate of depreciation
• Useful life of the asset
• Scrap value of the asset

Calculation Choices 
Depending on their own preferences, companies are free to choose from several methods to calculate the depreciation expense. To keep things simple, we'll summarize the two most common methods: 
 

• Straight-line method - This takes an estimated scrap value of the asset at the end of its life and subtracts it from its original cost. This result is then divided by management's estimate of the number of useful years of the asset. The company expenses the same amount of depreciation each year. Here is the formula for the straight-line method: 
  
  Straight line depreciation = (original costs of asset – scrap value)/estimated asset life 
   
• Accelerated Methods - These methods write-off depreciation costs more quickly than the straight-line method. Generally, the purpose behind this is to minimize taxable income. A popular method is the 'double declining balance', which essentially doubles the rate of depreciation of the straight-line method: 
  
  Double declining depreciation = 2 x straight line rate 
  Double Declining Depreciation = 2 x (original costs of asset – scrap value / estimated asset life)

The Impact of Calculation Choices 
As an investor, you need to know how the choice of depreciation method affects an income statement and balance sheet in the short term. 

Here's an example. Let's say The Tricky Company purchased a new IT system for $2 million. Tricky estimates that the system has a scrap value of $500,000 and that it will last 15 years. According to the straight-line depreciation method, Tricky's depreciation expense in the first year after buying the IT system would be calculated as the following:

($2,000,000 - $500,000)/15 = $100,000

According to the accelerated double-declining depreciation, Tricky's depreciation expense in the first year after buying the IT system would be this: 

2 x straight line rate = 2 x($2,000,000 - $500,000)/15 
2 x straight line rate = $200,000

So, the numbers show that if Tricky uses the straight-line method, depreciation costs on the income statement will be significantly lower in the first years of the asset's life ($100,000 rather than the $200,000 rendered by the accelerated depreciation schedule). 

That means there is an impact on earnings. If Tricky is looking to cut costs and boost earnings per share, it will choose the straight-line method, which will boost its bottom line. 

A lot of investors believe that book value, or net asset value (NAV), offers a fairly precise and unbiased valuation metric. But, again, be careful. Management's choice of depreciation method can also significantly impact book value: determining Tricky's net worth means deducting all external liabilities on the balance sheet from the total assets - after accounting for depreciation. As a result, since the value of net assets doesn't shrink as quickly, straight-line depreciation gives Tricky a bigger book value than the value a faster rate would give.

The Impact of Assumptions 
Tricky chose a surprisingly long asset life for its IT system - 15 years. Information technology typically becomes obsolete quite quickly, so most companies depreciate information technology over a shorter period, say, five to eight years. 

Then there's the issue of the scrap value that Tricky chose. It's hard to trust that a used, five-year-old system would fetch a quarter of its original value. But perhaps we can see the reason for Tricky's decision: the longer the useful life of an asset and the greater the scrap value, the less its depreciation will be over its life. And a lower depreciation raises reported earnings and boosts book value. Tricky's assumptions, while questionable, will improve the appearance of its fundamentals. 

Conclusion 
A closer look at depreciation should remind investors that improvements in earnings per share and book value can, in some cases, result from little more than strokes of the pen. Earnings and net asset value that are boosted thanks to the choice of depreciation assumptions have nothing to do with improved business performance, and, in turn, don't signal strong long-term fundamentals. 

Thank you all... Really explained well all of you... :)

But, what about the Tax Treatment... I mean IT Act allows Depreciation as an expense.... So lets assume Depreciation charged in P&L a/c is Rs 100, so at the end of year, u have 100 (according to Accounting treatment as a Non-cash expense) + 30% of 100 (i.e Tax rate of 30% on 100 = 30) is it... So in total u have 100+30 = Rs 130 is it at the end of the year as amount to replace the asset??

Plz let me know if i am right or wrong? How are these 2 co-related i.e Accounting and IT Treatment?

Mohit

differ the tax addition, tax is not associated with depriciation direct way, but depriciation reduces the tax liability. 

100 is available to you for new asset in future, which will get added in subsequent years, 

Cool... Thanks US Sharma :)