Financial Statements, Depreciation –Cash Flow

Depreciation definition in accounting


Depreciation means a fall in the value of an asset because of usage or with passage of time or obsolescence or accident. Every fixed asset looses its value, once it is put to use. It would be proper to consider some important definitions of depreciation. Depreciation may be defined as a measure of the exhaustion of the effective life of an asset from any cause during a given period Depreciation is the diminution in intrinsic value of the asset due to use and / or lapse of time.”


Financial statements of a company

A financial statement is a periodic report prepared from the accounting records of a company. Financial statement include the profit & loss statement (or income statement), & the balance sheet. Financial statements are usually compiled on a quarterly basis or on an annual basis.

Profit and Loss Account

Profit and Loss Account is a report of carrying on business during a certain period. The Companies Act, 1956 does not give any standard form in which this account is to be prepared. In practice, Profit and Loss Account is prepared in different forms based on the needs of the business. Whatever form of Profit and Loss Account may be, various items of income and expenditure of the business should be under the most convenient heads. The Profit and Loss Account must exhibit a true and fair view of the profit earned or loss incurred by the company during the year for reporting convenience, the Profit & Loss account is divided into.

  1. Trading Account or Manufacturing Account
  2. Profit and Loss Account

 Trading Account

The trading account is prepared to arrive at the gross profit earned by the organization over a specified period. This helps the organization to arrive at the cost of core activity & calculate the direct profit from its operations.

Financial statements balance sheet example

Balance Sheet

For preparing the Balance Sheet of a company, same principles are followed as for the Balance Sheet of a sole proprietor or a partnership firm. The main principle is that the Balance Sheet must exhibit a true and fair view of the financial position of the company at the close of the year concerned. This means that the position shown should not be better or worse than the actual position. Assets and Liabilities must be shown at their proper figures‑neither inflated nor deflated.

The balance sheet is a statement that summaries assets & liabilities of a business. The excess of assets over liabilities is the net worth of a business.

The balance sheet provides information that helps in assessing a company’s.

Long –term financial strength.
Efficient day-to- day working capital management.
Asset Portfolio.
Sustainable long – term performance.

The balance sheet of all real, personal & nominal (capital in nature) accounts are transferred from trial balance & grouped under the major heads of assets & liabilities. The balance sheet is complete when the net profit/loss is transferred from the profit & loss account.

The prescribed form of the Balance Sheet has been given in Part I of Schedule VI of the Companies Act, 1956.

Distinction between Company’s Balance Sheet and Partnership Firm’s Balance Sheet

Company’s Balance Sheet has to be prepared according to schedule VI prescribed under the Companies Act 1966,

There is no such schedule prescribed in the Partnership Act.

Company’s Balance Sheet has to be audited by a Chartered Accountant.

Audit of firm’s balance sheet is not necessary, however if turnover exceeds certain limit then it becomes mandatory to audit the books of accounts.

Here, it is important to note that depreciation is charged on all fixed assets except land. Usually the value of land appreciates over a period. The reason is that unlike other fixed assets like machinery, furniture it does not have finite economic life.

Characteristics of Depreciation

The above definition brings to highlight the following characteristics of depreciation:

  • Depreciation is a reduction in the book value of fixed assets.
  • It reduces the book value of the asset but not its market value.
  • Depreciation is a continuing process because the book value is reduced either with the asset or with a passage of time.
  • It takes place gradually unless there is a quick physical deterioration or obsolescence due to technological developments.
  • It is not the process of valuation of asset, it is a process of allocation of cost of the asset to the period of its life.
  • The term depreciation is used only for tangible fixed assets. This term is not used in the case of wasting and fictitious assets such as depletion of natural resources and amortization of goodwill respectively.

Depreciation meaning and example

Sometimes the terms depletion, obsolescence, amortization, etc., are used interchangeably with depreciation. But these terms are used in different contexts. Therefore, let us understand the basic distinction between depreciation and such other related concepts.

 Depreciation and Depletion. The term ‘depletion’ is used in respect of the extraction of natural resources like quarries, mines, etc., that reduces the availability of quantity of the material of asset. Depreciation refers to a reduction in the value of all kinds of fixed assets arising from their wear and tear.

Depreciation and Obsolescence. Obsolescence refers to decrease in usefulness caused on account of the asset becoming out of date. Old fashioned, etc., Depreciation, as stated earlier, is a loss in value of an asset generally arising on account of wear and tear The fact remains that obsolescence is regarded as one of the causes of depreciation.

Depreciation and Amortization The distinction between depreciation and amortization is that ‘amortization’ refers to writing off the proportionate value of the intangibles such as goodwill, copyright, patents, etc., while ‘depreciation’ refers to the writing off of the expired cost of the tangible assets like, machinery, building, furniture, etc.

Causes of Depreciation:-

Wear and Tear. Wear and tear is an important cause of depreciation in the cases of tangible fixed assets. It is mainly due to use of the asset. Efflux of Time. Some assets have a definite life period like a lease; on the expiry of the life the asset will cease to exist. Other assets, like plant and machinery, may not have a definite life; in their case the life is estimated. Obsolescence. If a better machine comes in market, the old machines may have to be scrapped even though they are capable of being used. It is a reduction in usefulness of the asset.

Accounting Concept of Depreciation:-

Accounting concept of depreciation means to distribute the cost of fixed assets as per its estimated life in a reasonable manner. According to this concept, in an accounting period, diminution in the value of assets can be charged to that accounting period,

Annual depreciation in the value of asses is like an expense which is due to use of assets in business functions and thus, is a charge on profits. Therefore, this is an expense like other expenses. Its provision is not optional but compulsory. If we do not deduct any expense from the income of an accounting period, the ascertained profit will be wrong and will not disclose corrects result of the business.

Cash flow statement and fund flow statement

Cash flow statement applicability

A statement prepared showing the flow of Cash during a period is known as Cash Flow Statement. The term ‘Flow’ means change or movement and’ Cash means Cash and Cash equivalents. Cash flow statement, therefore, is a statement & which reveals movement of Cash and Cash equivalents during a given period usually an accounting year. Thus, Cash flow statement, may be defined to be a summary of receipts and payments, reconciling the opening Cash (Cash or Cash equivalents) balance with the closing balance of a given period with information about the sources (inflow) and applications (outflow) from items appearing in the Balance Sheet and the Profit and Loss Account of the enterprise.

Cash flow statement explains reasons for the changes in Cash position of the enterprise. Transactions that increase the Cash position of the entity are labeled as ‘inflow’ of Cash and those which decrease the Cash position as ‘out flow ‘of Cash. Cash flow statement traces the various sources, which bring in Cash such as Cash from operating activities, investment activities and financing activities. In brief, a Cash flow statement shows the Cash receipts and payments during the period.

Cash flow statement and its advantages

The balance sheet discloses the financial position of the business on a particular date. It is merely a statement of the assets and liabilities. It depicts the effect of various transactions in a particular period and show the resources position after transactions in a period. The balance sheet at the end of the period is generally quite different from the balance sheet at the beginning of the year. But how the changes have come about is not reflected in the balance sheet.

The Analysis method, which discloses these changes, is called ‘Funds Flow Statement’. In short, funds flow statement is a statement, which is prepared to disclose the changes in financial data of balance sheets of two periods. The statement is a report on major financial operations, i.e., changes, flows or movements during the period. It is known by other names also: ‘Statement of Sources and Application of Funds, Statement of Changes in Financial Position’.

IPA offers  E Accounting Course in Delhi