Understanding depreciation
We ended the prior chapter with the initial balance sheet calculation, referred to as the gross block. This one will finalize the asset schedule and connect the information back to both the P&L and Balance sheet.
Currently, this is what the asset list looks like –
The gross block appears to be neat and orderly. We must now move on to determining the deprecation. The greatest difficulty with forecasting the total depreciation is calculating the current year’s number, as you are aware of, which comes from the P&L statement.
A look at this year’s depreciation, per the Profit & Loss report, reveals…
Investors commonly have difficulty understanding the difference between the accumulated depreciation shown on a balance sheet and the current year’s depreciation that appears in a P&L (in the expense section).
The depreciation value reported in the P&L for the current fiscal year is only relevant to that fiscal period. The finance team at the company reviews all existing assets (gross block) when determining the figure for the current year’s depreciation. Each new financial year brings with it a revised depreciation amount dependent on any updates to the gross block.
The balance sheet’s accumulated depreciation is cumulative in nature, meaning that the current year depreciation (from the Profit & Loss report) is simply added to the next year’s number, which produce the total for this year.
Don’t fret if this seems befuddling; you’ll soon comprehend it, but for the present I want you to consider the path we are taking.
We have already estimated the Gross block number. By projecting the current year depreciation figure to the P&L, we can then apply the base rule in the asset schedule and forecast its Accumulated Depreciation amount.
After forecasting the accumulated depreciation, we can compute the company’s netblock. This netblock figure will then be reflected in the balance sheet.
We make the process simpler and easier, and we save time.
Forecast the depreciation expense in the current year’s profit and loss statement.
Retrieve the forecasted netblock amount from the asset record and feed it back into the balance sheet.
Predicting this year’s depreciation relies heavily on methods and techniques used.
We’ll take a brief detour before continuing, which is relevant to our conversation.
Imagine yourself in the shoes of a freelance photographer with an unpredictable monthly income. You are responsible for handling your own finances, and you must be prepared to adjust according to the amount of work that comes your way.
Your October income amounted to 25K, and you shelled out 3K for leisure.
In November, how much do you reckon you should put aside for entertainment, given that your income is 30K?
The best approach is to stick with the same expenditure pattern as you did in October.
In October –
3000/25000
= 12%
Hence for September,
12% * 30000
= 3600
By applying the method of proportions, I am hoping to forecast depreciation for the current year.
For Year 5, the P&L showed Depreciation and Amortization of 41.71 Cr, while the balance sheet reported a Gross Block of 538.76Cr. This is estimated to reach 588.77 Cr in Year 6; what would you expect depreciation in that year to be?
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