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Depreciation - Concept and Factors

"Assets don't last forever - depreciation captures their gradual decline in value."

What is Depreciation?

Definition: The gradual and permanent decrease in the value of a fixed asset due to use, passage of time, or obsolescence.

Simple Meaning: Your car/computer/machine loses value every year—that loss is depreciation.

AS-6 Definition: Depreciation is the measure of wearing out, consumption, or other loss of value of a depreciable asset arising from use, effluxion of time, or obsolescence through technology and market changes.

Why Does Depreciation Occur?

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Examples:

  • Machinery: Continuous use wears out parts.
  • Building: Paint fades, structure weakens over time.
  • Vehicles: Mileage increases, engine efficiency decreases.
  • Laptops: New models with better features make old ones less valuable.

Need for Depreciation

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Depreciable vs Non-Depreciable Assets

Depreciable Assets

  • Machinery
  • Furniture
  • Vehicles
  • Buildings
  • Computers
  • Equipment

Non-Depreciable Assets

  • Land: Doesn't wear out (usually appreciates)
  • Current Assets: Stock, debtors (not fixed assets)
  • Intangibles: Goodwill (amortized, not depreciated)

Factors Affecting Depreciation

1. Original Cost

What it includes:

  • Purchase price
  • Installation charges
  • Transportation cost
  • Any other expenses to make the asset ready for use

Example: Machinery purchased for ₹5,00,000 + Transportation ₹10,000 + Installation ₹15,000
= Cost = ₹5,25,000

2. Estimated Useful Life

How long will the asset serve?

Different assets have different lifespans:

  • Computers: 3-5 years
  • Machinery: 10-15 years
  • Buildings: 30-60 years
  • Vehicles: 8-10 years

As per Income Tax Act: Standard rates are prescribed for each asset category.

3. Estimated Salvage/Scrap/Residual Value

What will the asset fetch when scrapped?

  • Machine cost ₹1,00,000
  • After 10 years, scraps metal can be sold for ₹10,000
  • Scrap Value = ₹10,000

Depreciable Amount = Cost - Scrap Value

Formula: Depreciable Amount

Depreciable Amount = Original Cost - Estimated Scrap Value

This is the total amount that will be charged as depreciation over the asset's useful life.

Example:

  • Cost: ₹1,00,000
  • Scrap Value: ₹10,000
  • Useful Life: 10 years
  • Depreciable Amount: ₹90,000
  • Annual Depreciation (SLM): ₹90,000 ÷ 10 = ₹9,000/year

Accounting Treatment of Depreciation

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Method 1: Direct Reduction

Journal Entry:

Depreciation A/c             Dr.    ₹10,000
    To Machinery A/c                    ₹10,000
(Being depreciation charged)

Asset shown in Balance Sheet:
Machinery at ₹90,000 (reduced value)

Method 2: Provision for Depreciation

Journal Entry:

Depreciation A/c             Dr.    ₹10,000
    To Provision for Depreciation A/c   ₹10,000
(Being depreciation charged)

Asset shown in Balance Sheet:

Machinery (at cost)                  1,00,000
Less: Provision for Depreciation       10,000
                                      --------
Net Book Value                         90,000

Advantage: Original cost remains visible.

Real-World Example

Amazon India - Warehouse Equipment

  • Purchased automated robots for ₹10 Crores
  • Useful life: 10 years
  • Estimated scrap value: ₹1 Crore
  • Depreciable amount: ₹9 Crores
  • Annual Depreciation: ₹90 Lakhs

This ₹90 Lakhs is treated as an expense in the P&L Account, reducing taxable profit and ensuring true profit calculation.

Depreciation vs Amortization vs Depletion

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Quiz: Depreciation Concept

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