Table of Contents

Depreciation

Depreciation is the gradual and permanent fall in the value of a business asset over time due to wear and tear, obsolescence, or usage. It is charged on fixed assets like machinery, buildings, furniture, computers, and vehicles.

Depreciation is recorded as an expense in accounts to show the true net profit, reflect the real value of assets in the balance sheet, and help plan for the replacement of old assets.

Example:

A machine costs ₹1,00,000 and has a useful life of 5 years.
Annual depreciation = ₹1,00,000 ÷ 5 = ₹20,000

Meaning and Advantages of Double Entry System

Definition of depreciation-

According to R.N. Carter, “Depreciation is the gradual and permanent decrease in the value of an asset from any cause”

According to J.R. Batliboi, “Depreciation means the permanent decline in the value of assets due to wear and tear or from any other cause.”

According to R.G. Williams, “Depreciation may be defined as a gradual deterioration in the value of assets due to use.”

Depreciation

“Depreciation is the gradual, continuous, and permanent decrease in the value of fixed assets (non-current assets) due to normal wear and tear, passage of time, and expected obsolescence in technology.”

20 transactions with their Journal Entries, Ledger and Trial balance

“Depreciation is the reduction in the value of fixed assets over time.”

In other words, the process of allocation of the cost of a fixed asset over its useful life is known as depreciation.

For example, an office chair is purchased for Rs. 25,000. The useful life of the chair is ten years, over which the cost of Rs 25,000 will be distributed. Each year’s allocation may be calculated as Rs. 2,500. Thus, Rs. 2,500 is the depreciation expense for each year.

Amortization:

“Amortization is the process of systematically writing off the cost of an intangible asset over its estimated useful life.”

Key points to remember for exams:

Applies only to intangible assets like patents, copyrights, goodwill, trademarks, and software.
Ensures matching of expenses with revenue generated by the asset.
Usually done on a straight-line basis (equal amount each year), unless stated otherwise.
Reduces the asset’s book value gradually in the balance sheet.

Example for exams:

A patent is purchased for ₹60,000, with a useful life of 6 years.
Annual amortization = ₹60,000 ÷ 6 = ₹10,000

Difference between Depreciation and Amortization

Basis	Depreciation	Amortization
Meaning	Depreciation is the gradual reduction in the value of tangible fixed assets.	Amortization is the gradual reduction in the value of intangible assets.
Assets Involved	Applied to tangible assets like machinery, building, furniture, vehicles.	Applied to intangible assets like goodwill, patents, trademarks, copyrights.
Method of Allocation	Allocation of cost of tangible assets over their useful life.	Allocation of cost of intangible assets over their useful life.
Residual Value	May have residual or scrap value at the end of useful life.	Usually, no residual value is left for intangible assets.
Accounting Standard	Governed by AS-10 (Accounting for Fixed Assets).	Governed by AS-26 (Intangible Assets).
Example	Machinery costing ₹5,00,000 depreciated over 10 years.	Patent costing ₹2,00,000 amortized over 5 years.

Features of Depreciation

1. Decrease in the Book Value of Fixed Assets (Non-Current Assets)

Depreciation causes a reduction in the recorded (book) value of fixed assets such as machinery, furniture, or buildings.
This reduction is shown in the balance sheet every year.
Example: If machinery worth ₹1,00,000 is depreciated by ₹10,000 in the first year, its book value in the balance sheet becomes ₹90,000.

2. Non-Cash Expense

Depreciation does not involve any actual outflow of cash.
It is only an accounting adjustment to spread the cost of the asset over its useful life.
Example: Charging depreciation of ₹10,000 on machinery does not require paying cash; it is only recorded in accounts.

3. Continuous Process

Depreciation is not a one-time event.
It is a continuous process, charged every year during the useful life of the asset.
Example: A machine will be depreciated every year till the end of its useful life, not just in the year of purchase.

4. Charge Against Profit

Depreciation is treated as a business expense and is charged to the Profit and Loss Account.
It is charged irrespective of profit or loss.
Example: Even if a business incurs a loss in a year, depreciation must still be recorded.

5. Gradual and Systematic Reduction

Depreciation represents a gradual, systematic, and permanent fall in the value of an asset over its useful life.
This ensures that the expense is fairly spread over the years the asset is used.

6. Reduction in Book Value, Not Market Value

Depreciation reduces only the book value (accounting value) of the asset, not necessarily its market price.
Market value may fluctuate due to demand, supply, or inflation, but depreciation is calculated based on cost and usage.
Example: A car in books may be valued at ₹5,00,000 after depreciation, but its market price may be ₹6,00,000 or even less.

7. Ongoing Process Until End of Useful Life

Depreciation continues to be charged every year until the asset becomes fully depreciated or is disposed of.
Example: A machine with a 10-year life will be depreciated every year until it is either sold or becomes scrap.

Causes of Depreciation

1. Continuous Use of Assets (Wear and Tear)

When assets like machinery, vehicles, and furniture are used regularly, they gradually lose their efficiency and value.
This physical deterioration is called wear and tear.
Example: A truck used for daily transport will require frequent repairs and will lose value every year.

2. Accidents

Unexpected events like fire, theft, or road accidents can reduce the value of assets suddenly, even if they are new.
Example: A new car getting damaged in a road accident will lose a major portion of its value immediately.

3. Obsolescence (Change in Technology or Fashion)

Assets may lose value before the end of their useful life due to new inventions, improved technology, or changes in demand.
Example:
- Old mobile phones losing value when new smartphones are launched.
- Typewriters becoming obsolete after the invention of computers.

4. Exhaustion (Elimination of Original Substance)

Natural resources such as mines, quarries, oil wells, and forests decrease in value as their supply is consumed or exhausted.
Example: A coal mine loses value as coal is continuously extracted from it.

5. Fall in Market Price (Permanent Decline in Value)

Sometimes the market value of an asset falls permanently due to economic conditions or new substitutes, leading to depreciation.
Example: An old model of a car losing value permanently because new fuel-efficient models are available at the same price.

6. Passage of Time

Some assets lose value simply because time passes, even if they are not in use.
Example:
- A building gets weaker with age.
- A patent or copyright loses value as its legal protection period expires.

Objectives of Charging Depreciation

To Determine the Correct Net Profit or Loss
- Depreciation is treated as an expense in the income statement.
- By accounting for depreciation, the cost of using assets is matched with revenue earned during the period.
- Example: If machinery worth ₹1,00,000 is used in production and depreciation for the year is ₹10,000, this ₹10,000 is recorded as an expense. This ensures the net profit reflects the true earnings.
To Prevent a Shortage of Capital
- Charging depreciation helps the business set aside funds gradually to replace worn-out assets.
- Example: A company charges ₹20,000 depreciation annually for its delivery trucks. After 5 years, ₹1,00,000 will be available to buy new trucks, preventing a sudden capital shortage.
To Show the True and Fair Value of Assets in the Balance Sheet
- Depreciation reduces the book value of assets to reflect their actual worth.
- Example: A building purchased for ₹5,00,000, with accumulated depreciation of ₹50,000, will be shown in the balance sheet at ₹4,50,000. This gives a realistic view of assets to stakeholders.
To Provide Facility for Replacement of Assets
- Regular depreciation ensures the business earns enough funds to replace old assets without financial strain.
- Example: A printing press charges ₹15,000 depreciation yearly. After 10 years, the total ₹1,50,000 can be used to buy new machinery.
To Avail of Income Tax Exemption
- Depreciation is an allowable deduction for income tax purposes, reducing taxable profit.
- Example: A company earns ₹5,00,000 profit but charges ₹50,000 as depreciation. The taxable profit becomes ₹4,50,000, lowering tax liability.
For Ascertaining the True Cost of Production
- Depreciation on assets used in production (like machinery) is included in product cost, giving the actual cost of manufacturing.
- Example: If production machinery incurs ₹10,000 depreciation yearly, this is added to the cost of goods produced, helping in accurate pricing.
To Meet Legal Requirements
- Accounting standards and laws require businesses to charge depreciation to reflect a fair view of financial statements.
- Example: Companies under the Companies Act are legally obliged to account for depreciation on fixed assets in their books.

30 transactions with their Journal Entries, Ledger, Trial balance and Final Accounts

Things to Keep in Mind While Calculating Depreciation

1. Cost Price of Assets

Cost price means the total cost incurred to bring the asset to its present location and condition, ready for use.
It includes:
- Purchase price
- Carriage or transport charges
- Installation and erection expenses
- Any other expense necessary to make the asset usable
Example: If a machine is purchased for ₹50,000, carriage charges ₹5,000 and installation expenses ₹10,000, then the total cost = ₹65,000.

2. Estimated Useful Life of Asset

Useful life is the period of time or the number of units of production for which an asset is expected to be used by the business.
Different assets have different useful lives.
Example:
- A computer may have a useful life of 3–5 years.
- A building may have a useful life of 40–50 years.

3. Residual Value (or Scrap Value)

After the completion of its useful life, an asset generally has some realizable value in the form of scrap or as a second-hand sale. This is called the residual value (or scrap value).

The portion of the asset’s cost that is to be depreciated is calculated as:

$Value\text{Depreciable Value} = \text{Cost of Asset} – \text{Residual Value}$

If depreciation is to be charged on the basis of useful life, then:

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

Example:
A machine costing ₹1,00,000 with an estimated scrap value of ₹10,000 and a useful life of 10 years will have a depreciable value of ₹90,000.
Thus, Annual Depreciation = ₹90,000 ÷ 10 = ₹9,000.

4. Obsolescence of Assets

An asset may become useless or outdated before the end of its useful life because of new technology, new inventions, or changes in demand.
This is called obsolescence.
Example: Typewriters became obsolete after the invention of computers.

5. Tax Provisions

In many countries, the rate and method of depreciation are sometimes guided by tax laws.
Businesses may have to follow specific rules (for example, Income Tax Act in India) when calculating depreciation for tax purposes.

6. Provisions of Accounting Law

Apart from tax laws, company law and accounting standards also lay down certain rules regarding depreciation.
For example:
- Companies Act in India prescribes the minimum rates of depreciation.
- Accounting Standard–10 (AS-10) provides guidelines for depreciation of fixed assets.

Basic Accounting Terms – 23 Important terms

Depreciation

JK BHARDWAJ