Depreciation

Objectives
After going through this lesson, the learners will be able to understand the following:
● Meaning of Depreciation
● Types of Depreciation

Content Outline
● Introduction
● Need for Charging Depreciation
● Methods of Depreciation
● Method of Recording Depreciation
● Summary

Introduction
For smooth running of business and enhancing its operations,every business acquired such
assets, which are utilized for a long period of time.. These assets are called fixed assets which
are used in business for facilitating its trading activities and enhancing its revenue earning
capacity. These assets are basically purchased by any business entity with the intention of its
permanent use and not for resale purposes.

The value of fixed assets decreases with wear and tear due to its constant use and with the
passage of time. Such gradual reduction or decrease in the value of fixed assets for the
purpose of earning revenue is called depreciation. Depreciation is closely related with the
determination of profit or loss for the period. Unless depreciation is charged to the revenues,
the true income of the business can not be ascertained properly. As such depreciation is a
revenue expense.

Meaning of Depreciation
Depreciation is a charge to the profit and loss account that accounts for the fall in value of an
asset during each year of its use. It represents that part of the cost of fixed assets to its owners
which is not recoverable when the asset is finally put out of use by its owners. Depreciation is
a measure of the wearing out, consumption or other value of a depreciable asset arising from

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the use, effluxion of time or obsolescence through technology and market changes.
Depreciation is allocated so as to charge a fair proportion of the depreciable amount in each
accounting period during the expected useful life of the asset. It also includes amortization of
assets whose useful life is predetermined. Examples of depreciable assets are machines,
plants, furniture, buildings, computers, trucks, vans, equipment, writing off of patents,
copyrights etc. Moreover, depreciation is the allocation of 'depreciable amount' from the
'historical cost' or other amount substituted for historical cost less estimated salvage value.It
is to be noted that land is one such asset whose value is not depreciated unless it has a limited
useful life.
Depreciation has a significant effect in determining and presenting the financial position and
results of operations of an enterprise. Depreciation is charged in each accounting period by
reference to the extent of the depreciable amount.
In this way, depreciation is defined as an allocation of the cost of assets over their useful life.
A systematic procedure for allocating the cost over the periods of its useful life in a rational
manner is called depreciation accounting.
Depreciable assets are assets which are expected to be used for more than one accounting
period, have a limited useful life and are held by an enterprise for use in the production or
supply of goods and services for rental to others or for administrative purposes.

Accounting Standard VI (Revised)

Objective:
● Provide basis for selection of method of depreciation
● Prescribe accounting treatment and disclosure requirements.

Scope:
● Applicability
○ All depreciable assets
● Not applicable on:
○ Forests, Plantation and similar regenerative resources
○ Wasting assets including expenditure for extraction of minerals, oils, natural
gas and similar non regenerative resources
○ Expenditure of research and development
○ Goodwill and other intangible assets

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 ○ Livestock
○ Land unless it has a limited useful life

Need for Charging Depreciation

The need for providing depreciation in accounting records arises from conceptual, legal, and
practical business consideration. These considerations provide depreciation a particular
significance as a business expense. Need for depreciation is justified on following grounds:
● Matching of Costs and Revenue
The rationale of the acquisition of fixed assets in business operations is that these are
used in the earning of revenue. Every asset is bound to undergo some wear and tear,
and hence lose value, once it is put to use in business. Therefore, depreciation is as
much the cost as any other expense incurred in the normal course of business like
salary, carriage, postage and stationary, etc. It is a charge against the revenue of the
corresponding period and must be deducted before arriving at net profit according to
Generally Accepted Accounting Principles (GAAP).
● Consideration of Tax
Depreciation is a deductible cost for tax purposes. However, tax rules for the
calculation of depreciation amount need not necessarily be similar to current business
practices,
● True and Fair Financial Position
If depreciation on assets is not provided for, then the assets will be over valued and
the balance sheet will not depict the correct financial position of the business. Also,
this is not permitted either by established accounting practices or by specific
provisions of law.
● Compliance with Law
Apart from tax regulations, there are certain specific legislations that indirectly
compel some business organizations like corporate enterprises to provide depreciation
on fixed assets.

Methods of Depreciation
The amount of depreciation to be charged for an accounting year depends on the depreciable
amount and the method of allocation. For this, two methods are mandated by law and

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enforced by professional accounting practice in India. These methods are a straight line
method and written down value method.
As per Accounting Standard-6, the selected depreciation method should be applied
consistently from period to period. Change in depreciation method may be allowed only
under specific circumstances.

Straight Line Method

Under the straight line method, a fixed and equal amount in the form of depreciation is
charged according to the fixed percentage on the original cost of the asset over its expected
useful life and is written off during each accounting period.
The formula used under straight line method is as follows:
𝐶𝑜𝑠𝑡𝑜𝑓𝐴𝑠𝑠𝑒𝑠𝑡𝑠−𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑛𝑒𝑡 𝑟𝑒𝑠𝑖𝑑𝑒𝑛𝑡𝑖𝑎𝑙 𝑣𝑎𝑙𝑢𝑒
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = 𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑈𝑠𝑒𝑓𝑢𝑙 𝐿𝑖𝑓𝑒 𝑂𝑓 𝑇ℎ𝑒 𝐴𝑠𝑠𝑒𝑡

Rate of depreciation under the straight line method is the percentage of the total cost of the
asset to be charged as deprecation during the useful lifetime of the asset. Rate of depreciation
is calculated as follows:
𝐴𝑛𝑛𝑢𝑎𝑙 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝐴𝑚𝑜𝑢𝑛𝑡
𝑅𝑎𝑡𝑒𝑜𝑓𝐷𝑒𝑝𝑒𝑟𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = 𝐴𝑐𝑞𝑢𝑖𝑠𝑖𝑡𝑖𝑜𝑛 𝐶𝑜𝑠𝑡
× 100

Consider the following example, the original cost of the asset is Rs. 2,50,000. The useful life
of the asset is 10 years and net residual value is estimated to be Rs. 50,000. Now, the amount
of depreciation to be charged every year will be computed as follows:
𝐴𝑐𝑞𝑢𝑖𝑠𝑡𝑖𝑜𝑛𝑐𝑜𝑠𝑡𝑜𝑓𝑎𝑠𝑠𝑒𝑠𝑡𝑠−𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑𝑛𝑒𝑡𝑟𝑒𝑠𝑖𝑑𝑒𝑛𝑡𝑖𝑎𝑙𝑣𝑎𝑙𝑢𝑒
𝐴𝑛𝑛𝑢𝑎𝑙 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝐴𝑚𝑜𝑢𝑛𝑡 = 𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝐿𝑖𝑓𝑒 𝑂𝑓 𝐴𝑠𝑠𝑒𝑡𝑠

𝑅𝑠.2,50,000−𝑅𝑠.50,000
𝑖. 𝑒 = 10
= 𝑅𝑠. 20, 000

The rate of depreciation will be calculated as :

𝐴𝑛𝑛𝑢𝑎𝑙 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝐴𝑚𝑜𝑢𝑛𝑡

𝑅𝑎𝑡𝑒𝑜𝑓𝐷𝑒𝑝𝑒𝑟𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = 𝐴𝑐𝑞𝑢𝑖𝑠𝑖𝑡𝑖𝑜𝑛 𝐶𝑜𝑠𝑡
× 100

From point (i), the annual depreciation amounts to Rs. 20,000.

Thus, the rate of depreciation will be

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 𝑅𝑠.20,000
𝑖. 𝑒 = 𝑅𝑠.2,50,000
× 100 = 8

Advantages of Straight Line Method

Straight Line method has certain advantages which are stated below:
● It is very simple, easy to understand and apply. Simplicity makes it a popular method
in practice;
● Assets can be depreciated upto the net scrap value or zero value. Therefore, this
method makes it possible to distribute full depreciable cost over useful life of the
asset;
● Every year, the same amount is charged as depreciation in the profit and loss account.
This makes comparison of profits for different years easy;
● This method is suitable for those assets whose useful life can be estimated accurately
and where the use of the asset is consistent from year to year such as leasehold
buildings.

Limitations of Straight Line Method

Although the straight line method is simple and easy to apply it suffers from certain
limitations which are given below.
● This method is based on the faulty assumption of same utility of the asset in different
accounting years;
● With the passage of time, work efficiency of the asset decreases and repair and
maintenance expense increases. Hence, under this method the total amount charged
against profit on account of depreciation and repair taken together will not be uniform
throughout the life of the asset, rather it will keep on increasing from year to year.

Written Down Value Method

Under this method, depreciation is charged as a fixed percentage calculated upon the original
cost and written down value (in subsequent years) of an asset, and is written off during each
accounting period over the expected useful life of an asset.
Formula for written down value method is :
𝑠 𝑛
R = [1- 𝑐
× 100

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Example:
If the purchase price of a plant is Rs. 4,00,000 and Rs. 1,00,000 is spent on its installation.
Estimated useful life and scrap value is 10 years and Rs. 2,00,000respectively. Calculate the
amount of depreciation for 5 years.
Solution: Since the rate of depreciation is not given,it will be calculated as:
10 2,00,000
R = [1- 41,00,000
= 26.07%

The amount of depreciation will be computed as:

26.07
First year: Rs. 41,00,000 × 100
= Rs. 10,68,870

Second year: Rs. 41,00,000 – 10,68,870 = Rs. 30,31,130

26.07
Rs. 30,31,130 × 100
= Rs. 7,90,216

Third year: Rs. 30,31,130 – Rs. 7,90,216 = Rs.22,40,914

26.07
Rs.22,40,914 × 100
= Rs. 5,84,266

Fourth year: Rs.22,40,914 – 5,84,266 = Rs. 16,56,708

26.07
Rs. 16,56,708 × 100
= Rs. 4,31,904

Fifth year: Rs. 16,56,708 –Rs. 4,31,904 = Rs. 12,24,804

26.07
Rs. 12,24,804 × 100
= Rs. 3,19,306

As evident from the example, the amount of depreciation has reduced year after year i.e., I
year Rs. 10,68,870, II year Rs. 7,90, 216, III year Rs. 5,84,266, IV year 4,31,904, V year
3,19,306 . . For this reason, it is also known as the reducing installment or diminishing value
method. This method is based upon the assumption that the benefit accruing to business from
assets keeps on diminishing as the asset becomes old . This is due to the reason that a
predetermined percentage is applied to a gradually shrinking balance on the asset account
every year. Thus, a large amount is recovered from depreciation charge in the earlier years
than in later years.

Advantages of Written Down Value Method

Written down value method has the following advantages:
● This method is based on a more realistic assumption that the benefits from assets go
on diminishing with the passage of time. Hence, it calls for proper allocation of cost
because higher depreciation is charged in earlier years when asset’s utility is more as
compared to later years when it becomes less useful;

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 ● It results into almost equal burden on profit or loss account of depreciation and repair
expenses taken together every year;
● Income Tax Act accept this method for tax purposes;
● As a large portion of cost is written-off in earlier years, loss due to obsolescence gets
reduced;
● This method is suitable for fixed assets, which lasts for long and which require
increased repair and maintenance expenses with passage of time. It can also be used
where obsolescence rate is high.

Limitations of Written Down Value Method

Although this method is based upon a more realistic assumption it suffers from the following
limitations.
● As depreciation is calculated at a fixed percentage of written down value, the
depreciable cost of the asset cannot be fully written-off. The value of the asset can
never be zero;
● It is difficult to ascertain a suitable rate of depreciation.

S. No. Straight Line Method Written Down Value Method

1. Calculation of depreciation is on Calculation of depreciation is on written

original cost down value

2. In this case , depreciation amount Depreciation amount keeps on reducing year

remains the same after year

3. At the end of estimated useful life The balance in the asset account will never
of the asset, the balance in the asset reduce to zero
account will be zero

4. Cost on account of depreciation and Cost on account of depreciation and

maintenance and repairs is low maintenance and repairs is more or less equal
during the initial or early years and throughout working life of the asset
high during last years of life of the
asset

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 5. It is suited for assets which get It is suitable for assets which require heavy
depreciated more on account of repairs in later years of their working life.
expiring of time e.g., patent, lease

Methods of Recording Depreciation

In the books of account, there are two types of arrangements for recording depreciation on
fixed assets:
● Charging depreciation to asset account or
● Creating Provision for depreciation/Accumulated depreciation account.

Charging Depreciation to Asset account

According to this arrangement, depreciation is deducted from the depreciable cost of the asset
(credited to the asset account) and charged (or debited) to the profit and loss account. Journal
entries under this recording method are as follows:
● For recording purchase of asset (only in the year of purchase)

Asset a/c Dr (with the cost of asset, etc.)

To Bank/Vendor a/c
● Following two entries are recorded at the end of every year
○ For deducting depreciation amount from the cost of the asset.
Depreciation a/c Dr. (with the amount of depreciation)
To Asset a/c
○ For charging depreciation to a profit and loss account.
Profit & Loss A/c Dr. (with the amount of depreciation)
To Depreciation A/c

Balance Sheet Treatment

When this method is used, the fixed asset appears at its net book value (i.e. cost less
depreciation charged till date) on the asset side of the balance sheet and not at its original cost
(also known as historical cost).

Creating Provision for Depreciation Account/Accumulated Depreciation Account

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This method is designed to accumulate the depreciation provided on an asset in a separate
account generally called ‘ provision’ for depreciation or ‘accumulated depreciation’. Such
accumulation of depreciation enables the asset account need not be disturbed in any way and
it continues to be shown at its original cost over the successive years of its useful life. There
are some basic characteristic of this method of recording depreciation, which are given
below:
● Asset account continues to appear at its original cost year after year over its entire
life;
● Depreciation is accumulated on a separate account instead of being adjusted into the
asset account at the end of each accounting period.
The following journal entries are recorded under this method:
● For recording purchase of asset (only in the year of purchase)
Asset a/c Dr. (with the cost etc.)
To Bank/Vendor A/c (cash/credit purchase)
● Following two journal entries are recorded at the end of each year:
○ For crediting depreciation amount to provision for depreciation account
Depreciation a/c Dr. (with the amount of depreciation)
To Provision for depreciation a/c
○ For charging depreciation to profit and loss account
Profit & Loss a/c Dr. (with the amount of depreciation)
To Depreciation a/c

Balance sheet treatment

In the balance sheet, the fixed asset continues to appear at its original cost on the
asset side. The depreciation charged till that date appears in the provision for depreciation
account, which is shown either on the “liabilities side” of the balance sheet or by way of
deduction from the original cost of the asset concerned on the asset side of the balance sheet.

Illustration 1
M/s Aditya and Bros. purchased a plant for Rs. 5,00,000 on April, 01 2010, and spent Rs.
50,000 for its installation. The salvage value of the plant after its useful life of 10 years is
estimated to be Rs. 10,000. Record journal entries for the year 2010-11 and draw up Plant
Account and Depreciation Account for first three years given that the depreciation is charged
using straight line method if :

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(i) The books of account close on March 31 every year; and
(ii) The firm charges depreciation to the asset account.
Solution
Books of Aditya and Bros.
Journal

Date Particulars LF Debit Credit

2010 Amount Amount
Rs. Rs.

Apr.01 Plant a/c Dr. 5,00,000

To Bank -a/c 5,00,000
(Purchased plant for Rs.5,00,000)

Apr.01 Plant a/c Dr. 50,000

To Bank a/c 50,000
(Expenses on installation)

2011
Mar.31 Depreciation a/c Dr. 54,000
To Plant a/c 54,000
(Depreciation charged on asset)

Mar.31 Profit and Loss a/c Dr. 54,000

To Depreciation a/c 54,000
(Depreciation debited to profit and loss
account)

Dr. Plant Account Cr.

Date Particulars J.F. Amount Date Particulars J.F. Amount

(₹) (₹)

2010 2011

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Apr. 01 Bank 5,00,000 Mar. 31 Depreciation 54,000
Bank (installation 50,000 Balance c/d 4,96,000
expenses)

5,50,000 5,50,000

2011 2012
Apr. 01 Balance b/d 4,96,000 Mar. 31 Depreciation 54,000
Balance c/d 4,42,000

4,96,000 4,96,000

2012 2013
Apr. 01 Balance b/d 4,42,000 Mar. 31 Depreciation 54,000
Balance c/d 3,88,000

4,42,000 4,42,000

2013
Apr. 01 Balance b/d 3,88,000

Dr. Depreciation Account Cr.

Date Particulars J.F. Amount Date Particulars J.F. Amount

(₹) (₹)

2011 2011
Mar. 01 Plant 54,000 Mar. 31 Profit and Loss 54,000

2012 2012
Mar. 01 Plant 54,000 Mar. 31 Profit and Loss 54,000

2013 2013
Mar. 01 Plant 54,000 Mar. 31 Profit and Loss 54,000

Working Notes

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 1. Calculation of original cost (Rs.)
i. Purchase cost 5,00,000
ii. Add: Installation cost 50,000
iii. Original cost 5,50,000
iv. Salvage value 10,000
v. Useful life 10 years

2. Depreciation amount = Rs. 5,50,000 – Rs. 10,000 = Rs. 54,000 p.a

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Summary
● Depreciation: It is a measure of the wearing out , consumption or other loss of value
of a depreciable asset arising from use or passage of time or obsolescence by
technology and market changes.
● Depreciable asset: Assets which are expected to be used for more than one
accounting period , have a limited useful life and /or held by a business for use in the
production or supply of goods and services.
● Useful life: A period over which a depreciable asset is expected to be used by an
enterprise.
● Method of Depreciation: The two important methods of depreciation are straight line
method and written down value method.

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