Depreciation

Definition
“Depreciation is the permanent and continuing
diminution in the quality, quantity or value of an
asset”

The Institute of Chartered Accountants of

England and Wales defines depreciation as “that
part of the cost of a fixed asset to its owner
which is not recoverable when the asset is finally
put out of use by him. Provision against this loss
of capital is an integral cost of conducting the
business during the effective commercial life of
the asset and is not dependent upon the amount
of profit earned”
Meaning of depreciation accounting
According to the American Institute of
Certified Public Accountants, ‘Depreciation
Accounting is a system of accounting which
aims to distribute cost or the basic value of
tangible capital assets less salvage(if any) over
the estimated useful life of the unit (which
may be group of assets) in a systematic and
rational manner. It is a process of allocation
and not of valuation
Causes of Depreciation
 Causes of Depreciation
• Physical Wear & Tear: When fixed assets are
put to use, the value of each asset may
decrease. Such decrease is due to physical
wear & tear.

• With passage of time: When the assets are

exposed to the forces of nature like weather,
winds, rains etc the value of such assets may
decrease even if they are not put to any use.
 Causes of Depreciation contd.
• Changes in economic environment: The value
of an asset may decrease due to decrease in
the demand of an asset. The demand for an
asset may decrease due to technological
changes, changes in the habits of customers
etc.

• Expiration of legal rights: When the use of an

asset (e.g. patents, leases) is governed by the
time bound arrangement, the value of such
assets may decrease with the passage of time.
 Need for charging depreciation
• To ascertain true results of operations: as it is
necessary to charge depreciation (cost) against
income
• To Present true and fair view of the financial
position: If the depreciation is not charged, the
unexpired cost of the asset concerned would be
overstated.
• To comply with legal requirements: Section
205(1) of the Companies Act, 1956 and section
32 of the Income Tax Act, 1961 requires it.
Factors affecting the amount of depreciation
• Historical Cost: of a depreciable asset implies the
cost incurred on its acquisition, installation,
commissioning and for additions to or
improvements thereof which are of capital nature
• Expected useful life: of a depreciable asset implies
either the period over which it is expected to be
used or number of production units expected to be
obtained from it
• Estimated residual value: of a depreciable asset
implies the value expected to be realised on its sale
or exchange on expiry of its useful life
 Methods of Recording Depreciation
There are two methods
1.When a provision for depreciation account is
maintained

2.When a provision for depreciation account is

not maintained
 Methods of Depreciation
Following are some of the methods of
providing depreciation
•Straight Line Method
•Diminishing Balance / Written Down Value
•Sum of years digits Method
•Machine hour rate Method
•Depletion Method
 Straight Line Method
• Also termed as Fixed Installment Method.

• Depreciation is charged evenly every year

through out the effective life of the asset.
• E.g. If an asset has been purchased for Rs 10,000
and it will have a scrap value of Rs 1,000 at the
end of its useful life of 10 years, the amount of
depreciation to be charged every year will be
computed as follows

Depreciation = (Rs 10,000 – Rs 1,000)/10 years

= Rs 900 each year

The depreciation can also be mentioned as a % of

cost of asset. In this case its 9% ( 10,000 / 900 X
100)
 Straight Line Method (cont)
Merits:
1. Easy to understand and easy to calculate
amount of depreciation.
2. The book value of the asset becomes zero
or equal to its scrap value at the end of its
useful life
Demerits
1. The total charge for use of asset goes on
increasing from year to year. But this
method charges depreciation uniformly over
useful life
 Diminishing Balance/Written Down Value
• Depreciation is charged on the book value or
WDV (written down value) of the asset each year.
• Book value is equal to year end value of the asset
less depreciation
• e.g. if the cost of an asset is Rs 20,000 and the
rate of depreciation is 10%, the amount of
depreciation in the first year will be a sum of Rs
2,000. In the second year, the depreciation will
be on the book value i.e. Rs 18,000 (20,000-
2,000) and so on
Merits:
1.The total charge (i.e. depreciation plus repairs)
remains almost uniform year after year, since in
earlier years the amount of depreciation is more
and the amount of repairs and renewals is less
whereas in later years the amount depreciation is
less and the amount of repairs and renewals is
more.
Demerits:
1.It is difficult to calculate rate of depreciation.
2.It takes very long time to write an asset down to
scrap value
 Sum of years digits (SYD) Method
• This method is on the pattern of WDV
method. The amount of depreciation charged
goes on decreasing every year.
• The depreciation is calculated as per following
formula:
 E.g. If cost of an asset is Rs 10,000 and it has
an effective life of 5 years the amount of
depreciation to be written off each year will
be computed as follows:
1st Year: 5 X 10,000 = Rs 3,333
1+ 2 + 3 + 4 + 5

2nd Year : 4 X 10,000 = Rs 2,666

1+2+3+4+5
3rd Year: 3 X 10,000 = Rs 2,000
1+2+3+4+5

4th Year: 2 X 10,000 = Rs 1,333

1+2+3+4+5

5th Year: 1 X 10,000 = Rs 667

1+2+3+4+5

Total depreciation = 3,333+2,666+2,000+1,333+667

for 5 years = 10,000 (Approx)
 Machine Hour Rate Method
• Also known as “Service Hours Method”
• The working life of machines is estimated in terms
of hours (not years) for which it is expected to be
used and depreciation for a particular year is
calculated on the basis of hours for which the
machine has worked during the year.
• Under this method, depreciation is provided by
means of a fixed rate per hour calculated by
dividing the value of asset by estimated number
of effective working hours during the useful life of
the asset.
 Depletion (Productive Output) Method
• The life of the asset is estimated in terms of
output which could be raised during its life and
depreciation is related to the quantity of
output and not passage of time
• This method is usually used for wasting assets
like mines, quarries etc
• Depletion refers to physical deterioration by
exhaustion of natural resources (ore deposits in
mines, oil wells, quarries, timber stands etc.)
Basis of Distinction Straight Line Method Written Down Value
Basis of calculation Depreciation is calculated at a Depreciation is calculated at a
fixed percentage on the fixed percentage on original
original cost in each year cost (in first year) and on book
value (in subsequent years)

Amount of depreciation The amount of depreciation The amount of depreciation

remains constant over the goes on decreasing
years

Total charge (depreciation Total charge in later years is
plus repairs and renewals) more as compared to that in
earlier years since the amount
of repairs and renewals goes
on increasing as the asset
grows older, whereas amount
of depreciation remains
constant year after year
Total charge remains almost
uniform since in earlier years
the amount of depreciation is
more and the amount of
repairs and renewals is less
and vice versa

Book Value Book value becomes zero or The book value of the asset
equal to scrap value does not become zero

Calculation – depre. Rate Easy to calculate the rate Difficult to calculate rate
 Important terms
• Book value / WDV as on date = Original cost –
depreciation till that date
• Book value as on date of sale = original cost –
total depreciation till date of sale
• Profit = Sale proceeds – book value as on the
date of sale
• Loss = Book value as on date of sale – Sale
proceeds