Meaning of Depreciation

Depreciation of an asset begins when it is available for use i.e. when it is in the location and condition necessary for it to be capable of operating in the manner intended by the management.

Depreciation is allocated so as to charge fair proportion of depreciable amount in each accounting period during the useful life of the asset.

The loss in value of assets employed for carrying on any business as an important part of business expenditure, it is necessary to compute amount of such loss and make provision and therefore arrive at the amount of profit or loss made by the business.

Depreciation is therefore a non-cash operating activity which is the result of qualitative wear and tear in the use of asset but it has been quantified by the use of accounting principles and assumptions in line with enterprise’s own accounting policies.

Depreciation and Cash Flows

Depreciation allocates the cost of tangible asset over the number of useful life to counter for decline in value over time. Depreciation allows the spread as expense of fixed asset over useful life of asset.

It helps the enterprise in taking tax deduction in the year the asset is bought. For example, If the company buys plant and machinery worth $10,000 and the useful life is 4 years.

The depreciation to be calculated for the next 4 years would be $2,500 per year. Since depreciation is listed as an expense, it reduces the amount of taxable income.

Of course, tax laws can vary, but if depreciation is allowed to be a tax-deductible expense, it will reduce the tax payment for a company. 

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Of course, tax laws can vary, but if depreciation is allowed to be a tax-deductible expense, it will reduce the tax payment for a company. 

Net Profit as in Income Statement is calculated by deducting expenses like depreciation from the income earned during the period.

Net Profit is however used as starting point in the cash flow statement.

As the depreciation is taken out when calculating net profit and it is not a cash expense, depreciation is added back while calculating the cash flow statement using indirect method.

In a nutshell, depreciation is an accounting measure and added back to revenue or net sales while calculating the company’s cash flow. Due to this depreciation does not impact the cash.

However, depreciation does have an indirect impact on cash flow. Depreciation can only be presented in cash flow statement when it is prepared using indirect method.

Presentation in Financial Statement:

Income Statement: With the help of useful life of asset and the appropriate rate, the depreciation needs to be calculated each year and is debited to Income Statement like any other operating expenses.

Balance Sheet: Depreciation reduces the value of assets over time. The depreciation over the number of years is added to get accumulated depreciation.

The historical value of asset is reduced by this accumulated depreciation so as to arrive at written down value of the asset.

Written down value of the asset is after all the wear and tear due to use which has been quantified in the form of depreciation.

Cash Flow Statement: Depreciation is non-cash item. So, virtually it has no impact on the cash movement and therefore does not impact cash flow statement directly.

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Presentation in Cash flow Statement Prepared Using Indirect Method:

Despite having no impact on cash flows, when we prepare the cash flow statement using indirect method, we start with net profit and add back all the non-cash items included in the income statement.

In this way, depreciation is added back to net profit as shown below in excerpts of cash flow statement using indirect method.

Year ended March 31 2019
Cash Flows from Operating Activities  
        Net Profit (Loss) XXX
        Add: Loss from discontinued operations XX
        Add: Non-cash items  
                 Depreciation and amortization* XX
   Impairment Loss XX
                  Employee Benefit expenses XX
                  Others XX
         Add/Less: Change in Assets and Liabilities XXX

*Amortization is treated exactly like depreciation. It is depreciation equivalent in case of intangible assets.