What is Depreciation AND Its Importance In Analysis of Balance Sheet

What is Depreciation  -  

Importance of Checking Depreciation in Financial Statements of Borrowers and  Need for  Ensuring that It is Provided in Full 

by

V Subramanian

What is Depreciation ?

1. Depreciation is a provision made against the normal wear and tear of the physical assets of an entity, duly taking into account the anticipated life time of each asset reflected in the books of account.  The accumulated depreciation will also take care of thereplacement cost of the physical assets, as and when necessary.    

Importance and Implications for Checking the Head of Depreciation in Financial Statements :

Banks must check the opening balance and closing balance of accumulated depreciation and cross check it with the figure shown under ‘depreciation for the current year’ in the Profit & Loss Account.   Since depreciation is a non-cash outflow,  most of the people do not takes it seriously.    It is not given the extent of importance it deserves.  Though depreciation is a non-cash outflow, it has got its own relevance and importance while studying the financial health of a commercial entity.  Depreciation affects profitability, distribution of profits in the form of dividends etc. and retained earnings.  As a result, the net worth of the unit is also affected. 

Let us see the importance and implications of providing for the right amount of depreciation.

1. (1) Banks must also check the opening balance and closing balance of accumulated depreciation and cross check it with the figure shown under ‘depreciation for the current year’ in the Profit & Loss Account.
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3. (2) At present, depreciation charged is added back, so as to arrive at the ‘cash profit’. Such cash profit is taken into account, while calculating ratios like DSCR (Debt Service Coverage Ratio), Interest Service Coverage Ratio etc.
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5. (3) Many business entities do not provide for depreciation as required under the statute every year, fearing it may erode their profitability and net worth.
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7. (4) Lower depreciation or no depreciation will help one present a rosy picture of the organisation under study.  It will help the management to distribute higher share of profit in the form of dividends etc. to the share-holders.

1. (5) There is a myth and misconception even among the educated people and many financial analysts/managers that a company which has a track record of giving consistently good dividend for many years in a row is financially sound and well managed.  To create this kind of wrong impression, no provision or lower provision for depreciation helps.
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3. (6) Lower depreciation leads to artificially boosted up profitability.  This necessitates payment of higher taxes than what is necessary.  Hence, tax authorities also do not bother much in case of lower provisioning made under the head ‘Depreciation’, by the individuals or institutions concerned.
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5. (7) If the depreciation debited to ‘Profit & Loss Account’ is credited to a new statutory head of account called “Physical Assets Redemption Reserve” and the amount outstanding under this head is also treated as part of ‘Net Worth’ of the business/trade unit for all practical purposes, then many organizations may come forward to provide for depreciation in their books to the required extent.
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7. (8) The reasons adduced by a borrower for not providing for required amount of depreciation must be fair and convincing.  Else, the bankers may at their discretion recalculate the correct amount of applicable depreciation and then recast the entire set of financial statements to ascertain the true state of affairs of the unit.