Introduction to Depreciation

1. Introduction to Depreciation

By Aarish Sir

In business, assets like machinery, furniture, buildings, vehicles, and equipment are purchased to help in producing goods and services. These are fixed assets and have a long useful life. However, they do not last forever. Their value decreases gradually with use, passage of time, or due to new technology. This decline in value is known as Depreciation.

Depreciation is an accounting concept that ensures the cost of a fixed asset is not charged in one year but spread over the years during which it is used. This gives a fair and accurate picture of profit or loss of the business.

2. Meaning of Depreciation

• Depreciation is a permanent, continuous, and gradual decrease in the book value of a tangible fixed asset due to use, wear and tear, passage of time, or obsolescence.

• It is not a sudden fall in value (like in case of accidents).

• It is a non-cash expense, meaning no money is spent at the time of recording depreciation—it is just a book entry.

Definitions:

• Institute of Chartered Accountants of India (ICAI):
  “Depreciation is a measure of the wearing out, consumption, or other loss of value of a depreciable asset arising from use, effluxion of time, or obsolescence through technology and market changes.”

• Accounting Standard (AS-6):
  “Depreciation is a systematic allocation of the depreciable amount of an asset over its useful life.”

3. Features of Depreciation

1. Decline in Value: Depreciation represents a fall in the book value of assets.

2. Gradual Process: It occurs gradually over time, not suddenly.

3. Non-Cash Expense: No actual outflow of cash is involved.

4. Charge Against Profits: It is shown as an expense in the Profit and Loss Account.

5. Related to Fixed Assets: Depreciation is charged only on tangible fixed assets (not on current assets like stock).

6. Allocation of Cost: It spreads the cost of the asset across its useful life.

4. Causes of Depreciation

1. Wear and Tear:

   • Physical deterioration due to regular use of assets.

   • Example: Machinery in a factory gets worn out after continuous use.

2. Obsolescence:

   • Due to invention of better technology, existing assets lose value even if physically in good condition.

   • Example: Typewriters lost value after the invention of computers.

3. Passage of Time (Effluxion of Time):

   • Certain assets decline in value simply with the passage of time.

   • Example: Patents, leases, and licenses.

4. Depletion:

   • Natural resources (mines, oil wells, quarries) lose value as they are extracted.

   • Example: A coal mine reduces in value as coal is mined out.

5. Accidents or Damages:

   • Unexpected damages may reduce the value of an asset suddenly.

5. Objectives of Providing Depreciation

1. Correct Calculation of Profits:

   • If depreciation is not charged, profits will be overstated.

   • Example: If machinery worth ₹1,00,000 is used for 10 years, charging full cost in one year is unfair.

2. True Financial Position:

   • Balance Sheet should show assets at correct value, i.e., cost minus depreciation.

3. Replacement of Assets:

   • Depreciation creates a reserve that helps in replacing assets after their useful life.

4. Legal Requirement:

   • As per Companies Act and Income Tax Act, depreciation must be provided.

5. Uniformity in Reporting:

   • Helps in making fair comparison of profits across different years.

6. Important Terms

• Cost of Asset: Purchase price + installation charges + freight + taxes + other incidental expenses.

• Residual Value (Scrap Value): Estimated value of asset at the end of its useful life.

• Depreciable Value: Cost of Asset – Residual Value.

• Useful Life: Estimated time period for which the asset can be used productively.

7. Methods of Depreciation

(A) Straight Line Method (SLM)

• Equal amount of depreciation is charged every year.

• Formula:
  Annual Depreciation = (Cost of Asset – Residual Value) ÷ Useful Life

Example:
Machinery Cost = ₹1,00,000, Scrap Value = ₹10,000, Life = 5 years
Depreciation = (1,00,000 – 10,000)/5 = ₹18,000 per year

Advantages:

• Simple and easy.

• Equal burden on each year.

• Suitable when asset gives equal utility every year.

Disadvantages:

• Book value may not represent true market value after some years.

• Not suitable for assets where utility decreases with time.

(B) Written Down Value Method (WDV)

• A fixed percentage of depreciation is charged every year on the book value of the asset.

• Formula:
  Depreciation = Opening Book Value × Rate of Depreciation (%)

Example:
Machine Cost = ₹1,00,000, Rate = 10%
Year 1: Depreciation = 1,00,000 × 10% = ₹10,000
Year 2: Depreciation = 90,000 × 10% = ₹9,000
Year 3: Depreciation = 81,000 × 10% = ₹8,100

Advantages:

• Book value never becomes zero.

• More scientific as asset provides higher benefits in earlier years.

• Accepted by Income Tax authorities.

Disadvantages:

• More complex than SLM.

• Depreciation is not uniform every year.

(C) Other Methods (Less Focus in Class 11 but useful to know)

1. Annuity Method – Depreciation + Interest = Equal amount annually.

2. Depreciation Fund Method – Amount invested outside business every year.

3. Insurance Policy Method – Premium paid on policy, maturity amount replaces asset.

4. Depletion Method – Used for mines, oil wells, forests.

8. Accounting Treatment of Depreciation

Method 1: When Depreciation is charged directly to Asset Account

• Journal Entry:
  Depreciation A/c Dr.
  To Asset A/c

• Transfer to Profit & Loss A/c:
  Profit & Loss A/c Dr.
  To Depreciation A/c

Method 2: When Provision for Depreciation Account is maintained

• Journal Entry:
  Depreciation A/c Dr.
  To Provision for Depreciation A/c

• Transfer to Profit & Loss A/c:
  Profit & Loss A/c Dr.
  To Depreciation A/c

9. Difference between SLM and WDV

Basis	Straight Line Method (SLM)	Written Down Value Method (WDV)
Basis of Calculation	Original Cost	Book Value at beginning of year
Depreciation Amount	Equal every year	Decreasing every year
Book Value at End	May become zero	Never becomes zero
Suitability	Assets with uniform utility (furniture, patents)	Assets with more use in initial years (machinery, vehicles)
Acceptance	Not accepted by IT authorities	Accepted by IT authorities

10. Advantages of Providing Depreciation

• Helps in showing true financial position.

• Ensures correct profit calculation.

• Accumulates funds for asset replacement.

• Meets legal requirements.

• Avoids over-distribution of profits.

11. Practical Examples (as in T.S. Grewal)

1. A machine purchased for ₹50,000, scrap value ₹5,000, life = 5 years. Calculate depreciation (SLM).

   • Depreciation = (50,000 – 5,000)/5 = ₹9,000 per year.

2. A machine purchased for ₹40,000, depreciation @ 10% WDV. Calculate depreciation for 2 years.

   • Year 1: 40,000 × 10% = ₹4,000

   • Year 2: 36,000 × 10% = ₹3,600

12. Importance of Depreciation in Business

• Reflects the real value of assets in the Balance Sheet.

• Ensures that profits are not overstated.

• Provides funds for future expansion and replacement.

• Helps in better decision-making for management.