DEPRECIATION AND AMORTISATION

Depreciation

Imagine you buy a brand-new car. It's shiny, has that new car smell, and runs smoothly. You
paid a good amount of money for it, and it's an exciting purchase. But over time, as you drive
it and as years go by, that car starts to lose some of its value. It’s no longer worth what you
initially paid for it. Maybe the leather seats wear out, or the engine gets a little less efficient.
That decrease in value is called depreciation.
Depreciation is the process by which an asset—like your car, equipment, or even buildings—
loses value over time. In accounting, depreciation helps businesses record that loss in value so
they can better manage their finances. For a business, understanding depreciation is essential
because it affects both the value of their assets and their financial reports.
Just like with your car, every asset in a company, whether it's machinery, vehicles, or
computers, goes through a similar process. Depreciation allows businesses to spread the cost
of an asset over its useful life, making it easier to manage taxes, profits, and future investments.
Understanding how depreciation works is key to smart financial decision-making!

Definition
Depreciation refers to the reduction in the value of a physical asset over time due to use, aging,
wear and tear, or obsolescence. It is the accounting process of allocating the cost of a tangible
asset over its useful life.

In accounting practice, the asset (purchase value plus installation cost) is recognized on the
balance sheet. The depreciation expenses of the asset is charged on the income statement, and
then the value on the asset balance sheet is also reduced. This continues until the cost of the
asset is fully expensed or the asset is sold or replaced.

Causes of Depreciation
 Wear and Tear: On the continuous use of the asset in business year after year, its value
keeps on decreasing every year due to wear and tear.
 Passage or Efflux of Time: Some assets lose their value over time, no matter if they are
used or not.
 Obsolescence: When the asset gets out of date, we call it obsolescence. This is an era of
technology, and technology updates every day. So, machines become obsolete faster than
ever before.
 Depletion or Exhaustion: Reduction in the value of wasting assets like minerals, mines,
etc. When more and more extraction from mines took place, its value decreased.
 Permanent fall in market value: When the market value of some assets decreases, then it
depreciates.
 Accidents: There are instances when an asset met an accident. In such a case, the asset
becomes worthless or useless.
Types of Depreciation
 Straight-Line Depreciation: Straight-line depreciation is a very common, and the
simplest, method of calculating depreciation expense. In straight-line depreciation, the
expense amount is the same every year over the useful life of the asset.

𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝐶𝑜𝑠𝑡 − 𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑆𝑐𝑟𝑎𝑝 𝑉𝑎𝑙𝑢𝑒

𝐴𝑛𝑛𝑢𝑎𝑙 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 =
𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑈𝑠𝑒𝑓𝑢𝑙 𝐿𝑖𝑓𝑒

Example: Consider a piece of equipment that costs Rs.25000 with an estimated useful life
of 8 years and no salvage value. The depreciation expense per year for this equipment
would be as follows:

 Declining Balance Depreciation: This method depreciates the asset more in the early
years and less as time goes on.
100
𝐴𝑛𝑛𝑢𝑎𝑙 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒 = 𝑋2
𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑙𝑖𝑓𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑎𝑠𝑠𝑒𝑡

Example: Consider a piece of property, plant, and equipment (PP&E) that costs Rs. 25000,
with an estimated useful life of 8 years and salvage value of Rs. 2500.

Depreciation rate = (100 X 2)/8 = 25%

The depreciation expense per year for this equipment would be as follows:

Question:
A company purchased a delivery truck that costs Rs.50000. The vehicle is estimated to have a
useful life of 5 years and an estimated salvage of Rs.15000. What will the depreciation value
of the truck under – (a) Straight line method, (b) Declining Balance Method?
Amortization

Imagine you decide to open a small bakery and you take out a loan to buy a commercial oven.
The oven is going to help your bakery run smoothly for many years, but instead of paying for
the entire oven upfront, you agree to pay back the loan over time. Each month, you make a
payment, gradually reducing the amount you owe. Over time, the value of the loan decreases
as you pay it off. Amortization works in a similar way, but it's not just about loans—it’s a
process used to spread the cost of an intangible asset (like a patent, copyright, or software) over
its useful life. So, if you spent money on a patent for a unique recipe, instead of expensing it
all at once, you could amortize the cost over several years, reflecting its gradual use. In
accounting, amortization helps businesses break down the cost of long-term intangible assets
into smaller, more manageable expenses over time. This gives a more accurate picture of the
company’s financial health and profits. So, just like your oven loan, amortization ensures that
costs are spread out and aligned with the asset’s value as it’s used over time.

Definition
Amortization is an accounting technique used to periodically lower the book value of a loan or
an intangible asset over a set period of time or over the item’s useful life. Concerning a loan,
amortization focuses on spreading out loan payments over time. When applied to an asset,
amortization is similar to depreciation. Amortization is usually done using the straight-line
method, meaning the asset’s cost is spread evenly over its useful life.
Example: A small business buys a software license for ₹25,000 that lasts 5 years. The business
amortizes ₹5,000 each year. Each year, they recognize ₹5,000 as an expense, making it more
manageable financially.

Importance of Depreciation and Amortization for Businesses

 Accurate Financial Reporting: Both methods ensure that business financial statements
reflect the actual value of assets and their gradual expense over time.
Example (Depreciation): Depreciating a building shows its current value on the balance
sheet.
Example (Amortization): Amortizing a brand name reduces its reported value over time on
financial reports.
 Reduces Taxable Income: Both depreciation and amortization lower taxable income by
spreading the cost of assets over time, leading to tax savings.
Example (Depreciation): A business deducts the depreciation of a delivery van to reduce
taxable income.
Example (Amortization): A business amortizes the cost of a software license to lower its
taxes.
 Helps in Planning for Future Expenses: Depreciation and amortization make it easier to
budget for future asset replacements or renewals.
Example (Depreciation): Depreciation of equipment helps a business plan for future
upgrades or replacements.
Example (Amortization): Amortization of a lease ensures a business is prepared when it
expires and needs to be renewed.
 Supports Long-Term Business Growth: These methods allow businesses to make better,
more informed decisions about investments, replacements, and overall growth strategies.
Example (Depreciation): Depreciation helps a business owner understand the value of their
assets, allowing for smart investment decisions.
Example (Amortization): Amortizing the cost of intellectual property helps a business
understand long-term costs and profits from innovations.