Depreciation is a fundamental concept in accounting that reflects the gradual reduction in the value of tangible assets over time due to factors such as wear and tear, usage, or obsolescence. This systematic allocation of an asset’s cost is essential for accurately representing a company’s financial position and ensuring compliance with accounting standards.

Definition of Depreciation in Accounting

In accounting terms, depreciation refers to the process of allocating the cost of a tangible fixed asset over its useful life. This allocation matches the expense of using the asset with the revenue it generates, adhering to the matching principle in accounting. By recognising depreciation, businesses can account for the declining utility of an asset and its eventual replacement.

Depreciation in Accounting: Meaning and Importance

Depreciation serves several critical purposes in accounting:

1. Expense Allocation: It distributes the cost of an asset over its useful life, preventing a significant one-time expense.
2. Asset Valuation: Reflects a more accurate book value of assets on the balance sheet.
3. Profit Measurement: Ensures the income statement reflects the cost associated with generating revenue.
4. Tax Implications: Depreciation is tax-deductible in India under the Income Tax Act 1961, reducing taxable income.

Accounting Depreciation Methods

There are various methods to calculate depreciation, each suitable for different types of assets and business scenarios. The most commonly used methods are:

1. Straight-Line Depreciation (SLM)

This is the simplest and most commonly used method. It allocates an equal depreciation expense annually over the asset’s useful life.

Formula:

(Cost of Asset – Salvage Value)÷Useful Life\text{(Cost of Asset – Salvage Value)} \div \text{Useful Life}(Cost of Asset – Salvage Value)÷Useful Life

Example

A company purchases machinery for ₹5,00,000, with an expected salvage value of ₹50,000 and a useful life of 5 years.

Annual depreciation expense:

(₹5,00,000−₹50,000)÷5=₹90,000 per year(₹5,00,000 – ₹50,000) \div 5 = ₹90,000 \text{ per year}(₹5,00,000−₹50,000)÷5=₹90,000 per year

2. Written Down Value (WDV) / Reducing Balance Method

This method applies a fixed percentage rate to the book value of the asset, leading to higher depreciation in the earlier years.

Formula:

Depreciation=WDV×Depreciation Rate\text{Depreciation} = \text{WDV} \times \text{Depreciation Rate}Depreciation=WDV×Depreciation Rate

Example

If a machine costing ₹5,00,000 has a 25% depreciation rate, depreciation for the first year would be:

₹5,00,000×25%=₹1,25,000₹5,00,000 \times 25\% = ₹1,25,000₹5,00,000×25%=₹1,25,000

For the second year, depreciation would be calculated on the remaining book value:

(₹5,00,000−₹1,25,000)×25%=₹93,750(₹5,00,000 – ₹1,25,000) \times 25\% = ₹93,750(₹5,00,000−₹1,25,000)×25%=₹93,750

3. Units of Production Depreciation

This method ties depreciation to the asset’s usage or output, making it suitable for manufacturing businesses.

Formula:

(Cost of Asset – Salvage Value)÷Total Estimated Production×Actual Production\text{(Cost of Asset – Salvage Value)} \div \text{Total Estimated Production} \times \text{Actual Production}(Cost of Asset – Salvage Value)÷Total Estimated Production×Actual Production

Example

A textile company purchases a machine for ₹10,00,000 with a salvage value of ₹1,00,000. The machine is expected to produce 2,00,000 units. If it produces 40,000 units in a year:

(₹10,00,000−₹1,00,000)÷2,00,000×40,000=₹1,80,000(₹10,00,000 – ₹1,00,000) \div 2,00,000 \times 40,000 = ₹1,80,000(₹10,00,000−₹1,00,000)÷2,00,000×40,000=₹1,80,000

4. Sum-of-the-Years’-Digits (SYD) Depreciation

An accelerated method that results in higher depreciation expenses in the earlier years.

Formula:

(Remaining Life of AssetSum of the Years’ Digits)×(Cost of Asset−Salvage Value)\left(\frac{\text{Remaining Life of Asset}}{\text{Sum of the Years’ Digits}}\right) \times (\text{Cost of Asset} – \text{Salvage Value})(Sum of the Years’ DigitsRemaining Life of Asset​)×(Cost of Asset−Salvage Value)

Example

For a 5-year asset, the sum of the years’ digits is 15 (5+4+3+2+1). In the first year:

(5/15)×(₹5,00,000−₹50,000)=₹1,50,000(5/15) \times (₹5,00,000 – ₹50,000) = ₹1,50,000(5/15)×(₹5,00,000−₹50,000)=₹1,50,000

Types of Depreciation in Accounting

Depreciation can be categorized based on the method applied:

• Time-Based Depreciation: Methods like straight-line and SYD that allocate depreciation based on time.
• Activity-Based Depreciation: Methods like units of production that allocate depreciation based on usage or output.

Depreciation Accounting Example

Example Scenario

A company purchases a delivery truck for ₹10,00,000. The truck has an expected useful life of 10 years and a salvage value of ₹1,00,000. Using the straight-line method:

• Annual Depreciation Expense:
  (₹10,00,000−₹1,00,000)÷10=₹90,000(₹10,00,000 – ₹1,00,000) \div 10 = ₹90,000(₹10,00,000−₹1,00,000)÷10=₹90,000
• Journal Entry Each Year:
  • Debit: Depreciation Expense ₹90,000
  • Credit: Accumulated Depreciation ₹90,000

After the first year, the book value of the truck would be ₹9,10,000 (₹10,00,000 – ₹90,000).

Common Mistakes to Avoid in Depreciation Accounting

1. Incorrect Depreciation Method Selection
   • Different methods are suitable for different types of assets. Choosing the wrong method can distort financial statements.
2. Ignoring Salvage Value
   • Businesses sometimes forget to factor in the residual value of an asset when calculating depreciation.
3. Not Considering Useful Life Properly
   • An incorrect estimate of useful life can overstate or understate expenses.
4. Failure to Update Depreciation Rates
   • Tax laws in India change, affecting depreciation rates under the Income Tax Act and Companies Act.
5. Not Recording Accumulated Depreciation Properly
   • Accumulated depreciation must be recorded in the balance sheet to reflect the book value of assets accurately.

Depreciation vs. Amortization vs. Depletion

What’s the Difference?

While depreciation, amortization, and depletion are all accounting methods for allocating asset costs over time, they apply to different types of assets.

Example Scenarios

• A factory machine loses value over time → Depreciation.
• A business patent expires after 10 years → Amortization.
• An oil company extracts crude oil from its fields → Depletion.

Each of these methods ensures that companies spread out costs fairly over time, rather than recording them as a one-time expense.

Depreciation in Financial Statements

How Depreciation Appears in Accounting Reports

1. Profit & Loss Account (Income Statement)
   • Depreciation is recorded as an operating expense, reducing taxable profits.
   • Example:
     • Before Depreciation: Revenue = ₹10,00,000, Expenses = ₹4,00,000, Profit = ₹6,00,000
     • After Depreciation (₹50,000): Profit = ₹5,50,000
2. Balance Sheet
   • The asset’s book value reduces each year due to accumulated depreciation.
   • Shown as:
     • Fixed Assets (Gross Value) – Accumulated Depreciation = Net Book Value
     • Example:
       • Machinery (Cost ₹5,00,000)
       • Less: Accumulated Depreciation (₹1,00,000)
       • Net Book Value = ₹4,00,000
3. Cash Flow Statement
   • Depreciation is a non-cash expense.
   • It reduces profits but doesn’t affect cash flow, so it is added back into the operating activities section of the cash flow statement.

Why is This Important?

• Helps businesses track asset value over time.
• Ensures accurate profit calculation.
• Plays a major role in financial decision-making and tax planning.

Depreciation for Small Businesses & Startups

Choosing the Right Depreciation Method for Your Business

For small businesses and startups, depreciation can significantly impact tax savings and financial planning. Here’s how:

1. Straight-Line vs. Written Down Value (WDV) Method

• Straight-Line Method (SLM): Best for consistent yearly expenses.
• WDV (Reducing Balance Method): More suitable for assets that lose value faster in early years, such as computers and vehicles.
• Which is Better?
  • If you need stable expenses → Use SLM
  • If you want higher deductions in the first few years → Use WDV

2. When to Use Accelerated Depreciation

• Helps reduce taxable income in the early years when cash flow is tight.
• The Income Tax Act, 1961 allows additional depreciation for certain industries like manufacturing.

3. Leasing vs. Buying Assets: How Depreciation Affects Your Choice

• Buying an Asset: You can claim depreciation but need high initial investment.
• Leasing an Asset: No depreciation benefits, but lease payments are tax-deductible as an expense.
• Best Strategy?
  • Buy long-term assets and depreciate them.
  • Lease assets that require frequent upgrades (e.g., computers).

4. How Startups Can Benefit from Depreciation

• Claim maximum tax deductions in early years using WDV.
• Use government schemes that allow accelerated depreciation for new businesses.
• Keep track of asset lifecycle for better financial planning.

Depreciation is a key aspect of accounting and taxation, helping businesses reflect the true value of assets, allocate expenses correctly, and comply with tax regulations. Understanding different depreciation methods ensures accurate financial reporting and tax planning.