When you buy a new machine for your business, after few years the machine has to be replaced. That is on one hand you used it for manufacturing, other side it wore & tore. After it wear and tear 100%, you buy a new machine.
Now what are the entries you have to mention in company’s balance sheet, so you keep a record and buy a new machine in advance. As this save your business from coming to standstill.
A company income statement consist of Total assets, Earnings & Expense.
You bought one new machine for 10 lakhs
Your company Asset now will be: Earlier assets value + 10 lakhs
Your company earnings are what you manufacture by using these assets.
After one year, your newly bought machine wear & tear (depreciate) 10%
Now your company assets value: earlier assets value + 9 lakhs. (10% of 10 lakhs depreciated)
Your company expenses will be: 1 lakh (That 10% which company consumed) + other expenses.
Lets say machine worked for 10 years roughly (useful life)
Expense after 10 years : 10 lakhs (Machine consumed 100%. 10% roughly each year)
Assets = 0 (Time to buy new machine) + Earlier assets value.
Definition of Depreciation:
“An exercise of distributing asset cost over it’s useful life, to give an idea about status of assets in economy.”
Why depreciation is important ?
When we calculate the income of nation, we have two concepts;
Gross National income – In which we eliminate depreciation and take the monetary value of brand new assets.
Net National income – We take the actual value (By considering the % of depreciation) of assets, thus monetary value of assets at present stage.
Say only 1 bike is manufactured in economy and nothing else.
Value of bike: 40000 rs. GNI = 40000 rs.
After 1 year bike depreciate 25%. GNI = 40000 but NNI = 30000 (25% less)
” GNI – Depreciation = NNI “