DEPRECIATION

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 the replacement 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.
importance and implications of providing for the right amount of depreciation.

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.

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.

Many business entities do not provide for depreciation as required under

the statute every year, fearing it may erode their profitability and net worth.

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.

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.
 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.

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.

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.