Depreciation is the structured allocation of the cost of the asset of a business to expense over the ‘useful life’ of the asset. For it to be allocated, it needs to charge a fair proportion of the depreciable amount in every accounting period during the expected useful life of the asset. In simpler words, the allocation of the asset’s depreciable amount over its approximate useful life is what you call depreciation.
However, many people still argue that depreciation can be a source of funds. In this article, we are going to discuss why it’s considered a source of funds and why it’s not.
What is Depreciation? (Easy Explanation)
In simple words, depreciation is the monetary value of an asset that decreases in the long run due to wear and tear obsolescence, or use. This ‘decrease’ is called or measured as depreciation. When depreciation is applied to business, it only happens when one of your business assets lose its value over time. Basically, there are several techniques for measuring the diminishing value of those assets and showing it in your business’s books.
Example of Depreciation
Since we’ve already defined what depreciation is, it’s imperative that we take a look at an example to better understand how it works. For instance, you’re a sidewalk florist who operates a cash-only business. During the most current year, you as a florist had earned cash revenues of $100,000 cash expenses of $70,000 and depreciation expenses of $8,000. Thus, your net income reported on the income statement was $22,000. This depreciation refers to a truck bought in an earlier year.
Reasons Why People Do Consider Depreciation a Source of Fund
1. Depreciation is subtracted from revenue to find out the profit. Therefore, a portion of revenue in the form of depreciation relies upon the business and expands its working capital. Depreciation becomes a fund since depreciation increases the working capital of the concern.
2. As the sale of every asset or its part is considered as a source of funds. Depreciation, being a part of fixed assets, is incorporated in the sale price, therefore, it’s also considered as a fund.
3. Depreciation acquires expenses of fixed assets. When depreciation is involved in the cost of production, which makes the sale price increase, then in return, it increases the revenue. This kind of revenue increases the recent assets of the business. Thus, depreciation can turn fixed assets into current assets, making it a source of funds.
4. Tax Depreciation offers a paramount source of funds in the Fund Flow Statement. Funds from operations are procured by adding depreciation to net profit.
Reasons Why People Don’t Consider Depreciation a Source of Fund
1. In business, your money is invested and it goes out and returns back for generating income. On the contrary, sources of funds are money, which proceeds from outside the business and increases its value. Depreciation is only a recovery of money that you’ve invested in the business and it’s not a form of addiction to the business’ worth. For this reason, it’s not a source of funds.
2. Depreciation is the process of allocating capital cost that’s invested in the fixed assets and not a process of generating revenue. It’s simply a circulation of money from fixed assets to the most recent assets, which is why it’s not a source of funds.
3. Depreciation is a form of expense that is still charged, even if there is no sale happening throughout the period. Therefore, depreciation cannot generate funds itself.
4. Depreciation is counted with profit from your operation that can be found in the Fund Flow Statement since it has been deducted to calculate the net profit. For this reason, it’s not considered as a source of funds.
5. If a non-expert is trying to increase his fund, and depreciation is treated as a source, then he can charge depreciation at a bigger rate to produce more funds, however, this is not practised as depreciation is not a source of funds.
Meanwhile, if you have a concern that earns enough profit from the amount of depreciation charged to the profit and loss account, then it can have an impact on its savings in the payment of tax together with dividend and should support in generating funds. If ever a concern earns a major profit and unrestricted depreciation then permitted under the Income-tax Act is charged to the profit and loss account, it must still lead to the generation of funds through savings in the payment of dividends.
On the Note
Despite these different arguments and reasons whether depreciation is a source of a fund or not, it may not be completely termed as a source of funds. Depreciation is rather a technique or strategy through which funds are not produced but only maintained. But depreciation may affect, indirectly, the fund arrangement of the concern. For example, depreciation can reduce tax liability and save the outflow of the fund.
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