The word ‘depreciation' originates from the word ‘deprecate' - indicating physical wearing out. Depreciation is how a Company recovers the cost of its more costly assets gradually, over the years they'll be used in business.

 

Types of Depreciation

-          Physical Depreciation: A machine wears out over a period of time in use, while generating revenues over that period, which cannot be expensed (entire cash shown as an expense) in the first year itself. It would distort the actual situation (make a huge dent in ‘Profits' figures), whereas it earns revenues over its full useful life.

-          Technological Depreciation: Introduction of better, faster (even cheaper) technology is regularly sending current designs of almost anything, to the trashcan.

-          Accidents/ Major breakdowns may also prematurely age an asset.

 

Thus, we allocate a portion of original cost as an expense each year, and balance cost v/s depreciation. Revenue received out of sales of the machine's output each year is matched with some portion of its cost.

 

Accidents or major breakdowns may also render a machine redundant, e.g. a car that has a burst engine cylinder block and damaged crankshaft/ gearbox.

 

Over a 10 year period, a machine may depreciate disproportionately e.g. a car; more in the first two years of its life, less and less as it gets older, till it plateaus out.

 

How much do we Amortize or Depreciate?

Cost of Machine + Installation + Directly Associated Costs = Total Cost - Salvage Value (At end of 10 yr. Period) = Depreciable base

 

Asset Value of Depreciation

-          Historical Cost is what we originally paid for the machine.

-          Cost of putting it into service e.g. wiring, plant modifications, special staff support (proportionate to salary /wages applicable depending on time spent by him in maintaining only that machine).

-          Money spent on putting the machine into service has to be added to the cost of the machine.

-          Taking An Income Tax Deduction in the first year itself is tantamount to taking an interest-free loan from the Govt., showing full amount as a deductible expense

-          Depreciation/tax payments are deferred (annually) to the future.