Depreciation Question

Posted on December 12th, 2010 by Sanjit Anand | Print This Post | Email This Post

Reader asked:

I am technical person and will you able tell where does depreciation really reflects in financial statement context.. we know it is a non cash item but , up to that extent profit gets reduced, so where does it really reflect in Balance sheet?

As mention is last post, various impact in financial impact would be:

• P&L = Depreciation expense
• Balance sheet = Accumulated depreciation
• Cash Flow Statement = Adjusted in Operating Cash Flow as a non cash expense

Here is explanation in layman language :

1. It's first recorded on Balance Sheet as a fixed asset when cash paid or liability incurred for payment.
2. Then your cost center is responsible for a recurring charge (depreciation), similar to a lease payment for the use of the fixed asset (office furniture, leasehold costs, PC equipments, phone system, etc.) over time until fully paid (depreciated).
3. Balance Sheet also keeps track of charges called accumulated depreciation until the recorded charges reduce the fixed asset to a zero book value. That's when it's fully recouped from cost centers.
4. Your P&L account is charged with the recurring charges (depreciation) for book purposes (intercompany allocation) which in essence requires no cash transfer because it's already paid/charged on fixed asset account.
5. Your cost center is to reimburse for the use of the fixed assets over the estimated life or statutory tax period, and as a result reduces your cost center's net profit.
6. Cash flow wise doesn't change because your cost center is one of many inside the same company's cash account. It's simply paying one hand to the other, so your cost center's profit gets debited on paper for depreciation, and it's a non-cash transfer - simply a journal entry the accountants keep track monthly, quarterly, semi-annually or annually.

In another word an accrual based accounting system, depreciation expense matches the cost of the asset with the revenues generated by it over it's useful life to get a better picture of true profit (or loss) in a specific period. If you were to expense the asset at the time of purchase (cash based) you would have artificially low profit in the period the asset was purchased and artificially high. On the Balance Sheet, Accumulated depreciation reduces the value of the asset to reflect the expensed portion moreover the the cash flow statement will give you the picture of cash movement in a specific period.

Hope this helps to understand. Wait for next post for accounting details for asset life cycle :)

1. Depreciation and Amortisation
2. Deep Drive : “Depreciation” in Oracle Fixed Asset
3. Detail of Fixed Asset Accounting
4. Understanding Depreciation Books: Back to Basic
5. FA : Capital Budgeting & Depreciation Forecast