Depreciation – Meaning, Causes & Objectives

You buy a car for ₹10 Lakhs. After 5 years, it's worth ₹4 Lakhs. Where did ₹6 Lakhs go? Depreciation!

What is Depreciation?

Definition: Gradual decrease in the value of a fixed asset due to use, passage of time, or obsolescence.

Simple Meaning: Wear and tear of assets

Accounting Definition: Systematic allocation of the cost of an asset over its useful life.

Why Depreciation Occurs? (Causes)

1. Physical Wear & Tear

• Machinery used daily → Parts wear out
• Building ages → Walls crack, paint fades
• Vehicle driven → Engine degrades

2. Passage of Time

• Lease expires
• Patent rights expire after 20 years
• Even if not used, asset ages

3. Obsolescence (Outdated Technology)

• Old computer vs new laptop
• Petrol car vs electric car
• 4G phone vs 5G phone

4. Depletion (Natural Resources)

• Coal mine → Coal extracted, mine empties
• Oil well → Oil pumped out
• Quarry → Stones removed

5. Accidents

• Machine breaks down
• Vehicle meets with accident

Objectives of Depreciation

1. Ascertain True Profit

Without Depreciation:

• Bought machine ₹10L in Year 1
• Used for 10 years
• Profit shown: High (no expense recorded)
• Wrong! Machine cost should be spread

With Depreciation:

• Year 1-10: ₹1L depreciation each year
• Profit: Correctly reduced
• Right! Matches expense with benefit

2. Show True Financial Position

Balance Sheet should show:

• Asset at current value, not original cost
• Machine bought at ₹10L, now worth ₹4L → Show ₹4L

3. Provide Funds for Replacement

• Depreciation is a non-cash expense
• Reduces profit → Reduces dividend payout
• Retains cash in business
• When asset needs replacement, funds available

4. Comply with Law

• Companies Act mandates depreciation
• Income Tax Act allows depreciation deduction

Important Concepts

Depreciation is NOT:

❌ Valuation of asset
❌ Cash outflow
❌ Creating a fund

Depreciation IS:

✅ Allocation of cost
✅ Non-cash expense
✅ Charge against profit

Example

Scenario: Bought delivery van for ₹5,00,000. Expected life: 5 years.

Annual Depreciation: ₹5,00,000 ÷ 5 = ₹1,00,000

Year 1:

• P&L Account: Depreciation ₹1,00,000 (Expense)
• Balance Sheet: Van ₹4,00,000 (₹5L - ₹1L)

Year 2:

• P&L Account: Depreciation ₹1,00,000
• Balance Sheet: Van ₹3,00,000

And so on...

Quiz

💡 Final Wisdom: "Depreciation is like aging - inevitable, gradual, and must be accounted for. Your assets age, your accounts must reflect it!"