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?
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
Why Charge Depreciation?
- True Profit Calculation: Without depreciation, profit is overstated. Depreciation is a cost of doing business.
- Asset Replacement: Setting aside money (via depreciation) helps replace the asset when it's fully worn out.
- Matching Principle: Cost of asset should be matched with revenue it generates over its life.
- True Financial Position: Shows the realistic value of assets in Balance Sheet.
- Tax Benefits: Depreciation reduces taxable profit (saves income tax).
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
| Method | Debit | Credit |
|---|---|---|
| Method 1: Charge to P&L | Depreciation A/c | Asset A/c |
| Method 2: Provision Method | Depreciation A/c | Provision for Depreciation A/c |
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
| Term | Applies To | Example |
|---|---|---|
| Depreciation | Tangible Fixed Assets | Machinery, Buildings |
| Amortization | Intangible Assets | Patents, Copyrights, Goodwill |
| Depletion | Natural Resources | Coal mines, Oil wells |
Quiz: Depreciation Concept
Test Your Knowledge
Question 1 of 5
1. Depreciation is charged on: