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What is Depreciation? Meaning, Methods, Calculations

What is Depreciation?

Depreciation is the reduction in the value of assets due to wear and tear. It is a method of allocation of cost of the asset over its useful life.

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

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

Considering depreciation as expense is very much required for successful finance management. For example a driver gives his car for tourism purpose, he has to consider the fact that 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 cost of car, its life, resale value after useful life and add it to other expenses for calculating total cost.

Depreciation is also allowed as a deduction from profits as per income tax act and also as per companies act. Although method of calculation is different under both acts and this difference also leads to creation of Deferred tax asset or deferred tax liability.

Common Methods or Types of Depreciation

  1. Written Down Value (WDV)
    WDV method of depreciation is the most common used method of depreciation. Also in income tax act, depreciation is allowed as per 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 reducing balance method. In WDV method the amount of depreciation goes on reducing with time. An asset gives more value to business in initial years then later year therefore this method is considered as 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 useful life of the asset
    c= Cost of the asset/Written down value of the asset
  2.  Straight Line Method (SLM)
    In this method equal amount of depreciation is charged on asset over its useful life. For eg asset is purchased for rs. 1,00,000 and useful life is 10 years with 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.
    Formula for calculating depreciation rate (SLM) = (100 – % of 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 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 be have a shorter life if it 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

Year Depreciation as per SLM Depreciation as per WDV
1 17,000 34,560.53
2 17,000 28,588.38
3 17,000 23,648.23
4 17,000 19,561.75
5 17,000 16,181.43
6 17,000 13,385.24
7 17,000 11,072.23
8 17,000 9,158.92
9 17,000 7,576.24
10 v 6,267.04
Total Depreciation 1,70,000 1,70,000

Accounting for Depreciation

Depreciation is an expense and reduces the book value of 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 profit and loss account and asset’s value is to be shown after reduction of depreciation in balance sheet.

There is also an 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 as Accumulated depreciation and depreciation for all assets are transferred into it. It is then showed as negative item in Fixed asset is 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 mandatory to charge depreciation in profit and loss account in 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 high number especially in industries required large plant and machinery. And this may lead to high distribution of profits to shareholders and thus non availability of funds when company is in need to replace the asset.
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