Depreciation is treated as an expense in the profit and loss account, and it helps in presenting the true value of assets in the balance sheet. It ensures that the cost of a fixed asset is spread over the years that it contributes to revenue generation, providing a fair view of financial performance and position.

2. Meaning of Depreciation

Depreciation can be defined as the permanent, continuous, and gradual reduction in the book value of a fixed asset due to usage, time, or obsolescence. It is a non-cash expense — meaning no actual cash outflow occurs when depreciation is charged; however, it affects profit and reduces the book value of assets.

Example:
If a company purchases machinery for ₹5,00,000 with an estimated useful life of 10 years and a scrap value of ₹50,000, the depreciation expense every year (using straight-line method) would be:

Depreciation per year=Cost – Scrap ValueUseful Life=5,00,000−50,00010=₹45,000\text{Depreciation per year} = \frac{\text{Cost – Scrap Value}}{\text{Useful Life}} = \frac{5,00,000 – 50,000}{10} = ₹45,000Depreciation per year=Useful LifeCost – Scrap Value​=105,00,000−50,000​=₹45,000

So, ₹45,000 will be charged as depreciation each year, reducing the book value of the machinery.

3. Need and Importance of Depreciation

1. Accurate Profit Measurement:
   Depreciation helps in matching the cost of using fixed assets with the revenue generated, ensuring the correct measurement of profit.

2. True Value of Assets:
   It shows the real and fair value of assets in the balance sheet.

3. Fund for Replacement:
   By charging depreciation, the business can accumulate funds to replace old assets with new ones in the future.

4. Legal Requirement:
   As per accounting standards and tax laws, charging depreciation is mandatory for true and fair financial reporting.

5. Helps in Decision-Making:
   It assists management in asset management, investment, and replacement decisions.

4. Causes of Depreciation

1. Wear and Tear: Regular use causes physical deterioration.

2. Passage of Time: Even unused assets, like buildings, depreciate over time.

3. Obsolescence: Assets become outdated due to new technologies.

4. Depletion: Natural resources like mines and oil wells reduce as they are used.

5. Accidents or Damages: Unexpected events can reduce asset life.

5. Types of Depreciation

Depreciation can be categorized in various ways based on its cause and nature:

(a) Physical Depreciation:

Occurs due to physical usage or wear and tear. For example, a delivery truck’s engine and body wear out over years of use.

(b) Functional Depreciation:

Happens when the asset becomes less efficient or unable to perform its intended function effectively.

(c) Obsolescence:

Results when an asset becomes outdated due to technological innovation. For instance, old computer systems depreciate quickly because of new models.

(d) Depletion:

Applies to natural resources such as mines, oil wells, and forests that reduce with extraction.

6. Methods of Depreciation

There are several methods for calculating depreciation. The most common methods are:

1. Straight Line Method (SLM):

Under this method, a fixed amount of depreciation is charged every year throughout the useful life of the asset. It is simple and suitable for assets that have uniform utility.

Formula:

Annual Depreciation=Cost of Asset – Scrap ValueUseful Life\text{Annual Depreciation} = \frac{\text{Cost of Asset – Scrap Value}}{\text{Useful Life}}Annual Depreciation=Useful LifeCost of Asset – Scrap Value​

Example:
A machine costing ₹2,00,000 with a scrap value of ₹20,000 and a life of 5 years will have:

Depreciation per year=2,00,000−20,0005=₹36,000\text{Depreciation per year} = \frac{2,00,000 – 20,000}{5} = ₹36,000Depreciation per year=52,00,000−20,000​=₹36,000

Book Value after 3 years = ₹2,00,000 – (₹36,000 × 3) = ₹92,000.

Advantages:

• Easy to calculate and understand.

• Suitable for assets with uniform benefits.

Disadvantages:

• Ignores the time value of money.

• Doesn’t account for higher maintenance costs in later years.

2. Written Down Value Method (WDV) / Diminishing Balance Method:

Depreciation is charged at a fixed percentage on the book value (cost minus accumulated depreciation). Hence, the amount of depreciation decreases every year.

Formula:

$$\text{Depreciation for the year}=\text{Book Value at beginning of year}\times \text{Rate of Depreciation}$$

Example:
If a car costs ₹10,00,000 with a 10% depreciation rate:

• Year 1: ₹10,00,000 × 10% = ₹1,00,000

• Year 2: ₹9,00,000 × 10% = ₹90,000

• Year 3: ₹8,10,000 × 10% = ₹81,000

Advantages:

• Reflects real usage pattern.

• Asset value never becomes zero.

Disadvantages:

• More complex calculation.

• Difficult to estimate actual life.

3. Units of Production Method:

Used when an asset’s life is measured in output units rather than time. Depreciation is based on the number of units produced.

Formula:

Depreciation per Unit=Cost – Scrap ValueTotal Estimated Units\text{Depreciation per Unit} = \frac{\text{Cost – Scrap Value}}{\text{Total Estimated Units}}Depreciation per Unit=Total Estimated UnitsCost – Scrap Value​ $$\text{Depreciation for Period}=\text{Depreciation per Unit}\times \text{Units Produced in Period}$$

Example:
A machine costs ₹5,00,000, scrap value ₹50,000, and produces 1,00,000 units in its life.

Depreciation per unit = ₹(5,00,000 – 50,000)/1,00,000 = ₹4.50 per unit.
If 20,000 units are produced this year, depreciation = ₹4.5 × 20,000 = ₹90,000.

4. Sum of Years’ Digits Method (SYD):

Depreciation is charged higher in earlier years and gradually reduces. It accelerates the depreciation rate.

Formula:

$$\text{Depreciation}=(\text{Remaining Life of Asset}/\text{Sum of Years Digits})\times (\text{Cost – Scrap Value})$$

Example:
If cost = ₹1,00,000, life = 5 years, scrap = ₹10,000:
Sum of digits = 1 + 2 + 3 + 4 + 5 = 15

Year 1 Depreciation = (5/15) × 90,000 = ₹30,000
Year 2 = (4/15) × 90,000 = ₹24,000, and so on.

5. Double Declining Balance Method (DDB):

This is a fast depreciation method used for tax purposes. It doubles the rate of depreciation used in the straight-line method and applies it on the book value.

Formula:

$$\text{Depreciation}=2\times \text{SLM Rate}\times \text{Book Value at Beginning of Year}$$

Example:
If the asset cost is ₹1,00,000, life is 5 years (SLM rate = 20%), then depreciation for the first year is:
= 2 × 20% × 1,00,000 = ₹40,000.

6. Annuity Method:

Depreciation is calculated by charging both interest on the capital invested and depreciation on the asset value. This method considers the time value of money.

7. Depletion Method:

Used for natural resources like mines, oil wells, etc., based on the quantity extracted.

Formula:

Depreciation per unit=Cost – Scrap ValueEstimated Quantity\text{Depreciation per unit} = \frac{\text{Cost – Scrap Value}}{\text{Estimated Quantity}}Depreciation per unit=Estimated QuantityCost – Scrap Value

7. Comparison Between SLM and WDV

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8. Accounting Treatment of Depreciation

Journal Entry:

1. When depreciation is directly written off:

   • Depreciation A/c Dr
     To Asset A/c

2. When provision for depreciation is maintained:

   • Depreciation A/c Dr
     To Provision for Depreciation A/c

In both cases, the depreciation expense appears in the Profit & Loss Account and the asset value is reduced in the Balance Sheet.

9. Example of Depreciation Accounting

A company purchased equipment for ₹1,20,000 on 1st April 2022 with an estimated life of 4 years and no residual value. Depreciation is charged using the straight-line method.

• Annual Depreciation = ₹1,20,000 / 4 = ₹30,000

• Journal Entry for each year:

  • Depreciation A/c Dr ₹30,000
    To Equipment A/c ₹30,000

After 4 years, the book value of the equipment becomes zero.