Depreciation and its Effects on Profits

Question: Discuss about the Depreciation and its Effects on Profits. Answer: Introduction: Depreciation is an expense presented in the profit and loss account and hence the amount of depreciation reduces the profit of the company. A company may use one of the methods of depreciation from straight line method, sum of year digits method, double declining balance and units of production method. The amount of depreciation differs in each method. (Atrill, Laney, Harvey, 2014) Under the straight line method, a uniform rate of depreciation is applied throughout the life of the project. Hence there is a stable effect on the profits of the company and a uniform reduction in the value of the assets on the balance sheet. Under sum of year digits method, higher amount of depreciation is charged in the initial years and lower amount in the latter years. Thus, due to higher depreciation in the initial years, the profits are affected more in the initial years and less in the latter years. Also the reduction in the value of assets in the initial years is higher. (quickbooks, 2016) In the given case, the by changing the depreciation method from straight line to sum of year digits method, the company will be able to reduce its profits in the early years of 2016 and 2017 and have better profits in the later years of 2018 and 2019. This is because under sum of year digits method, higher depreciation will be charged to the profit and loss account, thus resulting in lower profits whereas in the later years, the amount of depreciation will be lower as compared to that applied in 2016 and 2017, thus the impact on profits will be lower and hence will eventually increase the profits. so the higher depreciation expense which were to be applied under the straight line method in the later years of 2018 and 2019 would be applied in early years of 2016 and 2017, thus saving the company from higher expenses in 2018 and 2019 when the company is expected to make low profits. In this way, the profits of the company would be more or less stable throughout the 5 years period. The change in the method of depreciation is recalculated from the date of use of the asset. The deficiency or surplus due to the change on the method of depreciation is adjusted in the profit and loss account by passing the necessary adjustment entries. (mca.gov, NA) In the given case, surplus depreciation will be charged in 2015 as higher depreciation will be applied under sum of year digits method. The higher profits will be reduced by the amount of excess depreciation. Similarly for 2016 and 2017, when the profits are expected to be high, the amount of depreciation will be relatively higher than 2018 and 2019 and thus the impact on profits will be high in 2016 and 2017 as compared to 2018 and 2019. Thus with low depreciation expenses, the profits for 2018 and 2019 will increase. (gradestack, NA) Thus we see that the objective of having consistent profits over the next few years would be met by changing the method of depreciation from straight line to sum of year digits method. References Mca.gov, (NA), Accounting Standard (AS) 6, Depreciation Accounting, accessed online on 8th January, 2017, available at https://www.mca.gov.in/Ministry/notification/pdf/AS_6.pdf Atrill, P., Laney, E., Harvey, D., (2014), Accounting: An Introduction, 6th Edition, Australia, Pearson Education Gradestack, (NA), Change in Method of Depreciation, accessed online on 8th January, 2017, available at, https://gradestack.com/Fundamentals-of/Change-in-Method-of/Change-in-Method-of/22480-4463-54978-study-wtw QuickBooks, (2016), How Depreciation Affects your Profits, accessed online on 8th January, 2017, available at, https://quickbooks.intuit.com/r/accounting-money/how-depreciation-affects-your-profits/