When a business acquires or purchases fixed assets like machinery, the value of such assets reduces over time due to natural wear and tear. Companies are required to account for this value reduction, and this is where the concept of depreciation steps in.
Depreciation is an accounting method through which the cost of an asset is evaluated throughout its useful life. By using this method, companies evaluate the value of fixed assets in alignment with the revenue streams (as the cost is spread over a period of time). In this blog, we have explained the meaning of depreciation, different types of depreciation methods in accounting and how you can calculate depreciation.
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What is depreciation?
Depreciation is a gradual but steady reduction in the value of a tangible asset over time to account for the wear and tear that the asset suffers due to use. Depreciation, in other words, can help determine how much of an asset’s value has been realised over time and the current expected value of the asset, which is the projected future value of an asset or investment after a certain amount of time.
By accounting for depreciation costs in their income statements, companies can correctly estimate the revenue generated by the asset for a particular year.
Return on equity: Highlights
- Depreciation is the process of writing off the value of an asset over its useful life.
- In accounting parlance, depreciation helps match the expenses with the income generated by an asset, giving a clear picture of the revenues being produced by an asset.
- Tangible assets undergo depreciation, while intangible assets record value in terms of amortisation.
- The straight-line and written-down value methods are the most common modes used to calculate depreciation.
- Depreciation also helps in saving tax as it is allowed as an eligible expense from your business income.
Which assets depreciate with time?
Depreciation is applicable to both tangible (furniture, property, equipment, plant and machinery, etc.) and intangible (goodwill, patent) assets. For accounting purposes, depreciation is charged only on tangible assets. For intangible assets, the concept of amortisation is used.
How to calculate depreciation of an asset?
To ascertain how much a tangible depreciated over the course of period, you should know following things about the asset –
- Its actual value
- Date of purchase
- Expected life
- Expected salvage value ( resale value at the end of an asset’s useful life)
- The type and amount of depreciation per year through wear and tear
Types of depreciation
There is no definitive way for calculating depreciation on an asset, but most businesses often use two primary modes to calculate depreciation on their assets –
- Straight line method
The straight-line method of depreciation, or SLM, is the simplest method of calculating the depreciation of an asset. Under this method, the salvage cost of the asset is deducted from the overall cost of the asset. The remaining amount is divided by the asset’s useful life to give the per annum depreciation amount.
Amount of depreciation = (Cost of the asset – the salvage value) / useful life
For example, say you buy a piece of equipment worth Rs. 50 lakh, which has an expected life of 10 years. After 10 years, when you sell the asset, you expect a salvage value of Rs. 5 lakh. In this case, the depreciation would be calculated as follows –
Depreciation = (Rs. 50 lakh – Rs. 5 lakh) / 10 = Rs. 4.5 lakh per annum
So, you would deduct Rs. 4.5 lakh yearly as depreciation from the asset’s value.
Note: Under SLM, the amount of depreciation remains fixed throughout the asset’s useful life.
- Written down value method
Also called the reducing balance or diminishing balance method, the written down value (WDV) method is the most commonly used mode of calculating depreciation.
Under this method, depreciation is calculated based on the asset’s residual value, i.e., the asset’s value after deducting the cumulative depreciation. Usually, the depreciation rate is fixed, and every year, this rate is applied to the asset’s residual value.
Depreciation = Opening value of the asset at the start of the year * depreciation rate
Comparing types of depreciation
If you compare the two types of depreciation discussed above, here are some differences that you would find –
| Straight-line method | Written down value method |
| The depreciation amount remains fixed throughout the asset’s life | The depreciation amount changes and reduces every year |
| The depreciation rate is different every year | The rate remains the same every year |
| The value of the asset becomes zero after the useful life | The value of the asset does not become zero |
| It is a simpler method | It is a slightly complicated calculation |
Is depreciation a fixed cost?
Yes, depreciation is a fixed cost. Regardless of the mode you choose to calculate the depreciation amount, the cost would apply every year till you use the asset.
The depreciation cost will reflect in the income statement of your business. The amount of depreciation, however, might remain the same or change depending on which mode of calculation you use.
Causes of depreciation
Depreciation should be accounted for the following reasons –
- To write off the value of the asset over its useful life
- To comply with the regulations of the Companies Act, 2013
- To assess the actual profit earned from the use of the asset
- To account for the diminishing value of the asset due to regular wear and tear
- To get income tax benefits since depreciation allows for a deduction from your tax liability
How does depreciation affect tax liability?
The Income Tax Act of 1961 recognises depreciation as a valid business expense. This, in turn, helps reduce the amount of profit chargeable to tax. As the profit reduces, so does the tax liability.
Thus, by accounting for depreciation, one can save on taxes and get higher disposable profits for the business. Higher profits can directly impact business growth and increase shareholder confidence.
Conclusion
Understanding depreciation and its nuances are paramount if you are a businessman or an ordinary taxpayer. If you have a fixed asset, you can calculate depreciation using any of the above-mentioned methods and deduct the same from the asset’s cost. Consult your accountant before accounting for depreciation.
