BACKGROUND
Accountancy has many terminologies in its subject. The words used in the title of the blog are not new for a commerce person. Conceptually, they all are used for a similar purpose. But there is a difference among them. Today we are not going to elaborate on them technically. But I will try to explain in lay man’s language.
Basically depreciation is charged on tangible assets; amortisation is used for intangible assets while deferred expense is used for some specified expenses.
Let us discuss all 3 concepts one by one.
DEPRECIATION
When I took admission in commerce stream, the topic of depreciation was part of the curriculum of initial years itself. But the surprising thing was this topic was part of studies till the end of my CA course. So what can we derive from this fact?? It means depreciation can be simple as well can be complicated also. Don’t worry we will not discuss any complicated issues. Rather my purpose is to create interest for you all for this complicated subject.
Let us start with the history behind the depreciation.
History of depreciation
The modern sophisticated accounting system has given birth to depreciation. In earlier times when railroad systems were under development, it demanded heavy capital for their structuring. The concept of depreciation was developed to spread the cost to grow our railroad system over multiple years instead of expensing the cost at the time of the expenditure. This enabled the various railroad companies to show a profit and attract investors.
Gradually this concept has made its place in all the commercial activities. Over a period of time, accounting concepts have become more logical. And that also has supported the concept of depreciation.
Let us discuss why depreciation is needed….
Why is depreciation needed?
Business entities acquire tangible assets for running their business. Tangible assets cost considerably. If we book the entire cost of assets in the year of expenditure itself then it will give an unfair view of financial statements. It will absorb entire revenue and will show negative results of economic activity of the business. This is actually not the case. To give the correct view of financial results of any business, it is necessary to book such expenses which are incurred to generate any particular revenue.
And that is why depreciation is needed. It spreads the cost of assets over its useful life so that every year the expense of assets is booked to the extent it is used for generation of revenue.
Apart from matching cost and revenue, depreciation measures ageing effect for different classes of assets. Depreciation divides the cost of assets over its useful life based on its usage in economic activities. Based on that, a business can come to about replacement time of a particular asset also.
When an entity purchases fixed assets or constructs any long term assets they spend a considerable amount behind it. If they expense out the entire amount in the same year of spending then imagine what can happen??? Suppose an entity spends 100 lakhs for fixed assets and it has revenue of 70 lakhs. If they charge the entire 100 lakhs in the same year of spending then their revenue will show negative results. This treatment is wrong because assets have a long life and expending it out in a single year will show the wrong financial situation of the entity. Instead of that, if the cost of Rs.100 lakhs is spread over 5 years and every year an amount of Rs.20 lakhs is booked as depreciation in profit and loss account against revenue of Rs.70 lakhs then it will give a true and fair view of financial statements.
Definition of depreciation
As we discussed above, meaning of depreciation can be derived as under:
Depreciation is an accounting method of allocating the cost of a tangible or physical asset over its useful life or life expectancy. Depreciation represents how much of an asset's value has been used up.
Methods of depreciation
There are different methods of calculation of depreciation.
- Straight Line Method [SLM]
- Written down value method [WDV]
How to calculate and book depreciation?
Let us see how to book the cost of assets and its related depreciation in books using the following example.
Now Mr.X wants to understand how to book all these expenses. Let us guide him step by step.
Cost of tangible assets amounting to Rs. 4,00,000 [i.e. cost of plant and machinery, building and furniture 1, 00,000+2, 50,000+50,000] will be booked in the balance sheet on the assets side under the respective asset head.
Now let us come to depreciation on the same. We will not go into much technical grounds. So simply I will mention that as per accounting standards, there are two methods by which depreciation can be calculated. And those are SLM (straight line method) and WDV (written down method)/ reducing balance method.
Rates of depreciation are derived based on estimated useful life of each class of assets. And an entity is supposed to apply relevant rates while calculating depreciation for his/her assets.
In our example, let us count depreciation as per SLM method on plant and machinery assuming rate of depreciation to be 15% and residual value to be Rs.10, 000.
Annual Depreciation: [Acquisition cost of assets – Residual value of assets]* % of depreciation
So, Annual depreciation will be: [1, 00,000-10,000]*15% Rs.13, 500
Amount of depreciation will be booked as an indirect expense in the profit & loss account every year and cost of assets will be reduced to that extent.
Amount of depreciation under the SLM method will remain the same every year.
As mentioned above, depreciation for other tangible assets should be calculated and booked accordingly.
AMORTISATION OF EXPENSE
Like we discussed depreciation, amortisation was another topic which used to be a little tricky for most of the students. And I was also not different. In initial years of studies, generally fundamentals are not so clear so things look more difficult than they actually are. Amortisation of expenses was one such topic for me. This topic proves that famous proverb…”don’t judge a book from its cover”.
Likewise this topic is not difficult to understand at all but its name sounds so technical that in my study time I used to pray that questions regarding this should not be asked in exams.
I wish I could remove the fear from your mind which I had during my time of studying.
What is amortisation?
I am not much aware when and how amortisation of expenses has started. So we will not dig into the history of it.
First of all I will discuss what amortisation is. In simple terms, it can refer to the practice of expensing the cost of an intangible asset over time.
Why amortisation is needed?
The accounting principles say there should be matching of income and expense for a particular period of time to derive a true and fair picture of business activities.
Now assume if an entity spends “X” amount, the benefit of which will be available for more than one year and they expense out the entire amount in the year in which they incur it….then it will give a negative result in the year of expense and afterwards will show considerable profit.
This type of treatment can confuse investors and lenders the most. They will lose faith in business.
That’s why amortisation is needed. Amortisation will help to give balance and genuine results of business operations.
How to calculate and book amortisation of expense?
Mr.X has purchased copyright and patent for his business purpose. These are called intangible assets and they also carry long beneficial life and so according to basic matching concept of accountancy, cost of the same should not be written off in the year of purchase. It should be spread over its useful life.
Cost of intangible assets will be booked on the assets side of the balance sheet under their respective asset group and amortised amount will be booked as an indirect expense in profit and loss account every year.
So in our example the cost of patent & copyright together comes to Rs.5, 00,000 [3,00,000+2,00,000] will be booked as intangible assets on the asset side of the balance sheet.
Let us say, the life of a patent is 10 years and copyright is 5 years.
Amount of amortisation for patent (per year): Rs.30, 000 [3, 00,000/10]
Amount of amortisation for copyright (per year): Rs.40, 000 [2, 00,000/5]
Difference between depreciation and amortisation
Basic concept of both depreciation and amortisation is the same. The main difference behind them is depreciation is applicable for tangible assets while amortisation applies to intangible assets.
DEFERRED EXPENSE
Last but not the least, deferred expense as name itself suggests deferring means “postpone” any particular event. Deferred expense has the similar concept of depreciation and amortisation but it applies to different types of transactions.
I got to have transactions relating to this topic in subject of accountancy throughout the studies of my CA course. So we can say this topic is basic and is necessary to have knowledge about it.
Let us try to understand it in a simple way.
What is deferred expense?
A deferred expense is a cost that has already been incurred, but which has not yet been consumed. It will be spread over the period for which its benefit will be available.
Why is expense deferred?
In business, certain expenses are incurred/paid for more than one year due to many reasons. It can be start-up expenses, advertisement expenses, insurance expenses etc. they are paid in advance for safeguarding the assets/ availing added benefits.
The logic which applies to amortisation, the same applies to deferment also. According to the matching concept of accountancy, revenue and only its related expenses should be accounted for in a particular period. Any excessive booking of expenses will give an irrational picture of profitability of business.
That is why the concept of deferred expense is used to book expenses to the extent it is consumed.
How to calculate and book deferred expenses?
Mr.X has spent advertisement expense of Rs.1, 00,000 and insurance expense of Rs.90, 000. It should be apportioned over the years for which benefit is going to be available. In our example, advertisement cost is paid for 5 years so every year Rs.20,000 will be booked as an advertisement expense in profit & loss account and balance advertisement cost pending to be amortised will be booked as a prepaid expense on asset side of the balance sheet.
Same way, an insurance expense will also be booked.
I have tried to explain all three topics in the most simple way. Hope you will enjoy it.
