What is depreciation and why do businesses charge it?

What the interviewer wants to hear

• Spreads the cost of a long-term asset over its useful life
• Follows the matching principle
• Common methods: straight-line and written down value
• Depends on cost, residual value and useful life
• It is a non-cash expense

Model answer

Depreciation is the way we spread the cost of a long-term asset, such as a machine or a vehicle, over the years it helps the business earn revenue. If a machine costing ₹5 lakh will be used for five years, charging the whole amount in year one would make that year look terrible and the next four look too good. Charging part of the cost each year follows the matching principle. The amount depends on cost, expected residual value and useful life. The two common methods are straight-line, which charges the same amount every year, and written down value, which charges a fixed percentage of the reducing balance, so more in early years. Depreciation is a non-cash expense: it reduces profit and the asset’s carrying amount but does not use cash, which is why it is added back in the cash flow statement.

More easy Accountant questions

• Explain double-entry bookkeeping to someone new, using a simple example.
• What is the difference between cash basis and accrual basis accounting, and why do companies use accrual?
• Walk me through how you prepare a bank reconciliation statement.
• Explain CGST, SGST and IGST. When does each apply?
• How does a transaction travel from a source document all the way to the financial statements?
• Explain input tax credit under GST with a simple example.
• What is the difference between a provision and a reserve?
• How would you handle a weekly vendor payment run?
• Name the main financial statements and explain how they are linked.