Depreciation: Meaning, Formula, Calculation, and Business Importance

Definition of Depreciation

Depreciation is the systematic allocation of the cost of a tangible fixed asset over its useful life. It represents the reduction in the value of an asset due to wear and tear, usage, passage of time, or obsolescence.

Detailed Meaning of Depreciation

Every business uses assets such as machinery, vehicles, equipment, and buildings to generate income. These assets are not used up immediately but gradually lose their value as time passes. This decline in value is called depreciation.

Depreciation does not involve any cash outflow; instead, it is an accounting adjustment that helps spread the cost of an asset over several years. For example, if a company buys a machine for ₹10,00,000 with a useful life of 10 years, instead of charging the full cost in one year, the expense is spread equally (₹1,00,000 per year under straight-line method).

This ensures accurate profit measurement and shows the real value of assets in the balance sheet.

Concept Breakdown of Depreciation

• Asset Cost → Original purchase price + installation + transportation + taxes.

• Useful Life → Estimated time the asset will provide benefits.

• Residual Value (Scrap Value) → Value expected after useful life.

• Depreciable Amount → (Cost – Residual Value).

• Depreciation Method → System of allocation (Straight Line, Written Down Value, Units of Production, etc.).

Formula for Depreciation

Straight Line Method (SLM)

$$\text{Annual Depreciation} = \frac{\text{Cost of Asset – Residual Value}}{\text{Useful Life (Years)}}$$

Written Down Value Method (WDV)

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

Example Calculation

Cost of Machinery: ₹5,00,000
Useful Life: 5 years
Residual Value: ₹50,000

Straight Line Method (SLM):

$$\frac{₹5,00,000 – ₹50,000}{5} = ₹90,000 \text{ per year}$$

So, depreciation expense = ₹90,000 each year.

Journal Entry for Depreciation

At year-end, the entry is:

Depreciation A/c    Dr.   90,000
      To Machinery A/c          90,000

This reduces the asset’s book value in the balance sheet and records depreciation expense in the Profit & Loss account.

Detailed Illustration

Suppose ABC Ltd. purchases a truck for ₹12,00,000 on 01-Apr-2020. The useful life is 6 years with a residual value of ₹1,20,000.

Depreciable Amount = ₹12,00,000 – ₹1,20,000 = ₹10,80,000

Under SLM:

$$\frac{₹10,80,000}{6} = ₹1,80,000 \text{ per year}$$

Depreciation Schedule (Partial Table):

Year	Opening Value	Depreciation	Closing Value
2020-21	₹12,00,000	₹1,80,000	₹10,20,000
2021-22	₹10,20,000	₹1,80,000	₹8,40,000
2022-23	₹8,40,000	₹1,80,000	₹6,60,000

Key Features of Depreciation

• Non-cash expense.

• Systematic allocation of cost.

• Reduces asset value on balance sheet.

• Impacts profit measurement.

• Based on estimation (life, residual value).

Importance of Depreciation in Business

• Ensures true & fair profit reporting.

• Helps in tax planning (deductible expense).

• Maintains accurate asset valuation.

• Assists in pricing decisions.

• Provides funds for asset replacement.

Advantages and Disadvantages

Advantages:

• Spreads cost fairly over time.

• Improves financial accuracy.

• Provides tax benefits.

• Helps in capital budgeting decisions.

Disadvantages:

• Based on estimates (life, scrap value).

• Different methods give different results.

• Complex calculations for large businesses.

Usage of Depreciation

• Financial reporting (balance sheet & P&L).

• Tax compliance.

• Asset replacement planning.

• Loan & financing decisions.

Case Studies

Infosys Ltd. → Uses Straight Line Method for IT equipment depreciation as per Indian Companies Act.

Airlines Industry → Uses Units of Production method since aircraft life depends on flying hours.

Automobile Companies → Often prefer WDV method due to faster obsolescence.

Practical Example

A laptop purchased for ₹60,000 with a useful life of 3 years and scrap value of ₹6,000.

Depreciation (SLM):

$$\frac{₹60,000 – ₹6,000}{3} = ₹18,000 \text{ per year}$$

So, each year depreciation = ₹18,000.

Common Mistakes or Misunderstandings

• Treating depreciation as cash expense.

• Ignoring residual value in calculations.

• Using incorrect useful life estimates.

• Not aligning depreciation with tax laws.

Real-Life Applications and Legal Aspects

• Tax Laws: Depreciation is deductible under the Income Tax Act, 1961 in India.

• IFRS & GAAP Compliance: Different accounting standards mandate specific methods.

• Banking & Financing: Asset value assessment affects collateral valuation.

• Startups & SMEs: Critical for profit reporting and investor presentations.

FAQs

Q1. Is depreciation a cash expense?
No, it is a non-cash accounting expense.

Q2. Can land be depreciated?
No, land has unlimited useful life and is not depreciated.

Q3. Which method is best for depreciation?
Depends on asset type – SLM for uniform use, WDV for assets losing value faster.

Q4. Is depreciation mandatory?
Yes, companies must charge depreciation as per Companies Act and accounting standards.

Expert Tip from Learn with Manika

Always align your depreciation method with both business reality and tax regulations. For assets with quick obsolescence (like technology), WDV is better. For long-term stable assets (like buildings), SLM works best.

Related Terms

• Amortization
• Obsolescence
• Residual Value
• Fixed Assets
• Capital Expenditure
• Accumulated Depreciation