DEPRECIATION IN SIMPLE TERMS
Assume that a company purchased a machinery of Rs. 20 crore. This machine has a useful life of 10 years after which it will be sold off as scrap. The company will employ this machine in the production process for the next 10 years. Let us also assume that the company makes sales of Rs. 50 crore every year and all expenses come to Rs. 40 crore. So every year the company will make a profit of Rs. 10 crore as follows.
| Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | Year 6 | Year 7 | Year 8 | Year 9 | Year 10 | |
| Sales | 50 | 50 | 50 | 50 | 50 | 50 | 50 | 50 | 50 | 50 |
| Expenses | 40 | 40 | 40 | 40 | 40 | 40 | 40 | 40 | 40 | 40 |
| Profit | 10 | 10 | 10 | 10 | 10 | 10 | 10 | 10 | 10 | 10 |
The expenses of Rs. 40 crore mentioned above include various expenses such as raw materials, labour, repairs and maintenance, interest cost, selling expenses, tax, etc. But there is one more expense we should have taken care of.
The machine which we bought for Rs. 20 crore is also an expense. Cash has gone out of the business. We have purchased the machine in year 1. So year 1 will have total expenses of Rs.60 crore. Let us revise the above table.
| Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | Year 6 | Year 7 | Year 8 | Year 9 | Year 10 | |
| Sales | 50 | 50 | 50 | 50 | 50 | 50 | 50 | 50 | 50 | 50 |
| Expenses | 40 | 40 | 40 | 40 | 40 | 40 | 40 | 40 | 40 | 40 |
| Machine expense | 20 | – | – | – | – | – | – | – | – | – |
| Profit | -10 | 10 | 10 | 10 | 10 | 10 | 10 | 10 | 10 | 10 |
Now, we have a loss of Rs. 10 crore for the first year. We have put the machine cost of Rs. 20 crore as expense in year 1. The other expenses are Rs.40 crore, so total expenses are Rs. 60 crore. The income is only Rs. 50 crore so we are saying there is a loss.
However we are making an error. The machine will be put to production use for 10 years. For 10 years, the machine will contribute to income generation – not just in the first year. We have to match revenue and costs. For the years 2 to 10, there is revenue contributed by the machine. But where is the cost? The entire cost of the machine is put under year 1 itself. So there is a mismatch here.
What is the correct way? Since the income from the machine will flow for 10 years, the cost of the machine should come in all the 10 years. Then we would have matched the revenue and cost since income will come from the machine for 10 years and for all those 10 years we will have a cost.
Now that we have decided every year there should be a machinery expense, the next question is how much should this expense be? The total cost of the machine is Rs. 20 crore. Let us split this Rs. 20 crore across all the 10 years equally i.e. Rs. 2 crore per year. Now, let us revise the above table once again.
| Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | Year 6 | Year 7 | Year 8 | Year 9 | Year 10 | |
| Sales | 50 | 50 | 50 | 50 | 50 | 50 | 50 | 50 | 50 | 50 |
| Expenses | 40 | 40 | 40 | 40 | 40 | 40 | 40 | 40 | 40 | 40 |
| Machine expense | 2 | 2 | 2 | 2 | 2 | 2 | 2 | 2 | 2 | 2 |
| Profit | 8 | 8 | 8 | 8 | 8 | 8 | 8 | 8 | 8 | 8 |
We have now arrived at profit of Rs. 8 crore per year.
At this juncture, let me tell you a very important point. The actual cash of Rs.20 crore has gone out in the year 1 itself. No machinery supplier will wait for 10 years for payment. He will not agree for the machine cost of Rs. 20 crore to be repaid as Rs. 2 crore payments for the next 10 years. The entire Rs. 20 crore payments have gone out in year 1 itself. What we have shown in the above table – machine expense of Rs. 2 crore per year is only a book entry. It is only to comply with the basic accounting concept of matching. Only for that purpose we have shown the machine expense of Rs. 2 crore per year. In reality, the payment is not made like this. It is not Rs. 2 crore for next 10 years; it is Rs. 20 crore payment in year 1 itself.
The point I am trying to make here is that depreciation is a non-cash item. It is only a book entry. We are just splitting the cost of Rs. 20 crore over 10 years and showing Rs. 2 crore per year. It is only for accounting purpose.
The Rs. 2 crore per year which we put in the above table is called depreciation. Simply put, depreciation is allocating the cost of an asset over the useful life of the asset. So in our example the cost of the machine is Rs. 20 crore and the useful life is 10 years. So depreciation was 20/10 = 2.
There are many ways to calculate depreciation. The two most common methods are straight line method and written down value method. Of these two, written down value method is more common. As a credit officer, you need not actually calculate depreciation. It is furnished in the balance sheet of the company. However if you are interested in the calculation, please refer to any good book on credit appraisal.
To summarise, in the course of business, we incur various costs such as raw materials, wages, etc. Just as we are consuming raw material in the manufacturing process, in a way we are also consuming the machine. That is because a machine will be subjected to wear and tear as it is used. Its performance declines as the days go by and finally by the end of, say, 10th year it will become useless. So we are consuming the machine in the process. So this consumption expense is to be accounted for just the same way as raw material consumption is accounted for. So the way of looking at depreciation is that it is the cost of the fixed asset just like any other expense – except that it is non-cash item.
creditappraisal.in 