What Is Depreciation?

Depreciation is the reduction in the value of assets due to wear and tear.

Every asset is subject to wear and tear in the ordinary course of its use and also with the passage of time. The cost of the asset is allocated over time and considered an expense.

It is applied to long-term assets which give benefits for many years. For example on plants & machinery, vehicles, computers, furniture, building, etc. The land is not subject to wear and tear and thus depreciation is not levied on land but applicable on a building.

Considering depreciation as an expense is very much required for successful financial management. For example, a driver gives his car for tourism purposes, he has to consider the fact that the car has a limited useful life and he needs to replace that after some years. For that, while calculating its operation cost, he has to consider the cost of the car, its life, and the resale value after its useful life and add it to other expenses for calculating the total cost.

Depreciation is also allowed as an expense as per the income tax act and also as per the companies act. Although the method of calculation is different under both acts and this difference also leads to the creation of Deferred tax assets or deferred tax liability.

Common Methods Or Types Of Depreciation

Written Down Value (WDV) Method

WDV method is the most commonly used method of depreciation. Also in the income tax act, depreciation is allowed as per the WDV method only.

In this method depreciation is charged on the book value of asset and book value is decreased each year by the depreciation.For eg- Asset is purchased at rs. 1,00,000 and depreciation rate is 10% then first year depreciation is rs. 10,000(10% of rs. 1,00,000), second year depreciation is rs. 9,000 ( 10% of 90,000 [1,00,000 – 10,000]) and third year depreciation is rs. 8,100 ( 10% of rs. 81,000 [90,000 – 9,000]).

This method is also called the reducing balance method. In the WDV method, the amount of depreciation goes on decreasing with time. An asset gives more value to a business in the initial years than a later years, therefore, this method is considered as the most logical method of depreciation.

Formula for calculating depreciation rate (WDV) = {1 – (s/c)^1/n } x 100
n = Remaining useful life of the asset (in years)
s = Scrap value at the end of the useful life of the asset
c= Cost of the asset/Written down value of the asset

 Straight Line Method (SLM)

In this method, an equal amount of depreciation is charged on the asset over its useful life. For Example – an asset is purchased for rs. 1,00,000 and useful life is 10 years with a salvage value of Rs. 10,000 then depreciation is charged at Rs. 9,000 for each of the 10 years. (1,00,000 – 10,000)/10.

The formula for calculating depreciation rate (SLM) = (100 – % of the resale value of purchase price)/Useful life in years
Depreciation = Purchase Price * Depreciation Rate or (Purchase price – Salvage Value)/Useful Life

There are also other methods of depreciation but they are not often used such as depreciation on the basis of units of production.

In companies act the depreciation rate is also based on the number of shifts. Logically an asset is expected to have a shorter life if it is used extensively.

Example –

Cost of asset = 2,00,000
Salvage value = 30,000
Useful Life = 10 Years

And thus Depreciation rate as per SLM = (100-15)/10 = 8.5%
Depreciation rate as per WDV = 17.28

Accounting For Depreciation

Depreciation is an expense and reduces the book value of an asset. Therefore a simple journal entry is to be passed at the end of the year. For example

Depreciation A/c Dr    10,000
To Computer A/c             10,000

Thus depreciation is shown as an Indirect expense in the debit side of the profit and loss account and the asset’s value is to be shown after the reduction of depreciation in the balance sheet.

There is also another method of accounting for depreciation, although it is rarely used. In this method rather than reducing the value of asset another account is credited named Accumulated depreciation and depreciation for all assets are transferred into it. It is then shown as a negative item in Fixed asset is the balance sheet.

Benefits/Need Of Charging Depreciation

1. Tax Benefit – Depreciation is allowed as an expense under Income tax and therefore it is important to consider it to save income tax.
2. Mandatory under companies act – It is compulsory to charge depreciation in the profit and loss account in the companies act 2013.
3. Real Profit – If it is not considered then expenditure on behalf of fixed assets is not considered and the profit may be shown as a high number, especially in industries requiring large plants and machinery. Also, this may lead to the high distribution of earnings to shareholders and thus non-availability of funds when a business is in need to replace an asset.