What is Depreciation?
Depreciation can be defined as the cost reduction of a fixed asset in a manner systematically designed to reduce the value of the asset to zero. Depreciation reflects the wear and tear in assets that are incurred as a result of the usage of the asset.
In typical accounting terms, depreciation can be defined as a method to allocate the cost of the tangible fixed asset over the useful life of the asset. This is to account for the decline in the value of the asset over the course of time.
Depreciation is a non-cash expense, but it is mandatory for all organizations to depreciate their fixed assets over the useful life of the asset in order to reflect the actual position of the fixed assets in the Balance Sheet of the company.
There are two most common methods of depreciation used by organizations. They are referred to as Straight Line Method and Reducing Balance Method (also referred to as Double Declining Method).
Accounting Treatment of Depreciation
Depreciation is a non-cash expense. However, it has a significant impact on the financial statements of the company, since it directly impacts the profitability of the company. When it comes to depreciation, there are two different accounting impacts that organizations need to make amends in. These accounts, along with their details and accounting importance are as follows:
- Depreciation: Depreciation is an expense from the perspective of the company. Despite the fact that it does not result in cash outflow, yet it still impacts the profitability of the company. Therefore, it is debited to the Income Statement as an expense. In order to record the depreciation expense for a given year, the following journal entries are made:
- Accumulated Depreciation: Accumulated Depreciation is the aggregated amount of deprecation that has been charged by the organization on a given fixed asset. It is a contra-asset account, since it reduces the carrying value of assets on the Balance Sheet of the company. Every year, depreciation charge is credited to the Accumulated Depreciation account, and the amount is then netted from the Fixed Assets so that they represented at the fair value of the asset.
Therefore, it can be seen that depreciation has a two-fold impact. It impacts both, the Income Statement as well as the Balance Sheet. The only difference, however, is the fact that Income Statement is only charged with the amount that is relevant for the current year, whereas the Balance Sheet is impacted by the Accumulated Depreciation, i.e. aggregated depreciation over the course of years over which the asset has been used.
Classification of Depreciation
Depreciation is classified as an expense. This is because it is a cost that is incurred as a result of the usage of the asset. This might comprise of accounting for wear and tear of the asset, or simply the fact that the cost of the asset needs to be spread over the useful life of the asset.
The purchase of fixed assets is a substantial investment from the perspective of the company. Once purchased, it is impractical for the company to record it as an expense in one go. This would greatly impact the Income Statements and reported Net Income for the year. Therefore, using depreciation, the cost of the asset is allocated over the useful life of the asset.
Therefore, when assets are depreciated, they are expensed in the Income Statement.
Example of Depreciation
The concept of depreciation is illustrated in the following example:
Harry Co. is a manufacturing concern dealing with textile units. In 2018, they procured a new stitching unit worth $100,000. They decided to depreciate the equipment using the Straight Line Method. The useful life of the asset was 10 years, and it had no expected salvage value.
|Cost of the Asset||$100,000||$100,000||$100,000|
|Carrying Value of the Asset||$90,000||$80,000||$70,000|
In the example mentioned above, it can be seen that the depreciation expense stayed the same across all the years, i.e. $10,000. This amount is going to be expensed to the Income Statement for the given year. In other words, the yearly depreciation amount, i.e. $10,000 is going to be expensed from the Income Statement every year.
In the same manner, it can be seen that Accumulated Depreciation increases across the years. The Carrying Value of the Asset is going to be mentioned in the Balance Sheet of the company, in order to reflect Accumulated Depreciation.
Is Depreciation an overhead expense?
Having established the fact that depreciation is considered to be an expense in the financial statements, it is important to consider the correct classification and categorization of expense.
It must be noted that expenses are divided into two categories, Direct Expenses, and Indirect Expenses. Indirect Expenses are also referred to as overheads. Direct Expenses are expenses that are incurred as a result of the core operations of the organization. These expenses directly fluctuate with the level of output of the company. Hence, they are referred to as Direct Costs, or Direct Expenses, since they are directly correlational to the level of output of the company.
On the other hand, indirect expenses, or overheads are expenses that are incurred by the company regardless of the level of output the company operates at. These are fixed costs that the company needs to bear, even if they are operating at zero output. Examples of overheads include rent, salaries, and marketing expenses.
As far as deprecation is concerned, it is considered as an overhead expense. This is because the depreciation of the asset is not contingent on the level of output a firm operates at. Hence, this implies that the depreciation charge is not going to change depending on the level of output of the company.
In accordance with the consistency principle of accounting, companies need to be consistent with their accounting policies. For example, if they choose to depreciate an asset using the Straight Line Method, they are supposed to continue doing that regardless of the usage of the asset. They cannot choose to change depreciation methods without any strong rationale.
Hence, it is classified as an indirect expense because the depreciation charge is contingent on two parameters, the cost of the asset, and the depreciation policy of the company. Both these parameters are exogenous with the output produced by the company, and hence, they are consistent across the course of years.
Even in the case of the Reducing Balance Method (or, Double Declining Method), the depreciation charge does not change based on output. It is consistent with the policy in place, and the methodology adopted by the organization. Therefore, depreciation is classified as an overhead cost and subsequently subtracted from the Gross Profit of the company.
Depreciation Cost for Manufacturing Concerns
Manufacturing Concerns have a separate manufacturing account, where all the manufacturing costs are calculated. These manufacturing costs are then transferred to the Income Statement of the company (primarily the Trading Account).
When calculating manufacturing costs, depreciation on the factory equipment is also charged as manufacturing overhead. The amount is then transferred to the Income Statement as an aggregated manufacturing cost. However, depreciation charged on the other equipment, other than manufacturing related equipment is still deducted from the gross profit.