Imagine buying a brand-new car.
The moment you drive it out of the showroom, its value starts dropping. The same happens to machines, furniture, buildings, and every other fixed asset a business owns. That drop in value which is gradual, systematic, and inevitable that is what we call Depreciation.
Source: Pixabay
What is Depreciation?
Depreciation is the systematic allocation of the depreciable amount of an asset over its useful life. In simple words, it is a way of spreading the cost of an asset over the years in which it is used. This ensures that the cost of using the asset matches the revenue it helps generate. No business can ignore it – doing so would overstate profits and mislead stakeholders.
Need for Charging Depreciation
1. Wear and Tear: Physical deterioration due to use (e.g., machine parts wearing out).2. Obsolescence: New technology makes old machines less efficient, even if they still work.
3. Legal Requirement: Companies Act mandates depreciation before declaring dividends.
4. Matching Concept: Expenses must match revenues. Depreciation ensures asset cost is charged over its useful life.
5. True and Fair View: Shows realistic value of assets in Balance Sheet.
Factors Affecting Depreciation
| Factor | Explanation |
|---|---|
| Cost of Asset | Includes purchase price, freight, installation charges, and any expenses to bring it into usable condition. |
| Residual Value | Estimated value at the end of its useful life. Deducted from cost to find depreciable amount. |
| Useful Life | Period over which the asset is expected to be used – measured in years, production units, or machine hours. |
Methods of Depreciation
a. Straight Line Method (SLM)
This is the simplest and most widely used method. Depreciation is equal every year. The formula:
Depreciation per year = (Cost – Residual Value) ÷ Useful Life
Example: Machine purchased for ₹1,00,000, residual value ₹10,000, useful life 5 years.
| Year | Depreciation (₹) | Book Value (₹) |
|---|---|---|
| 1 | 18,000 | 82,000 |
| 2 | 18,000 | 64,000 |
| 3 | 18,000 | 46,000 |
| 4 | 18,000 | 28,000 |
| 5 | 18,000 | 10,000 |
Notice how the charge stays constant each year – perfect for assets that wear out evenly over time.
b. Diminishing Balance Method (Written Down Value – WDV)
This method applies a fixed percentage rate to the book value at the beginning of each year. Depreciation is higher in early years and lower later.
Example: Machine cost ₹1,00,000, rate 20% per annum.
| Year | Opening Value (₹) | Depreciation (20%) | Closing Value (₹) |
|---|---|---|---|
| 1 | 1,00,000 | 20,000 | 80,000 |
| 2 | 80,000 | 16,000 | 64,000 |
| 3 | 64,000 | 12,800 | 51,200 |
This method is ideal for assets that lose value quickly in the early years, like technology or vehicles.
c. Annuity Method
This method considers interest on capital invested as well as depreciation. Each year, the same amount is charged to P&L (Depreciation + Interest), but the proportion of interest decreases and depreciation increases over time.
Example: Asset cost ₹1,00,000, interest rate 5%, useful life 3 years. (For simplicity, assume annuity factor is 0.3672 – giving annual charge = ₹36,720)
| Year | Opening Value (₹) | Interest (₹) | Depreciation (₹) | Closing Value (₹) |
|---|---|---|---|---|
| 1 | 1,00,000 | 5,000 | 31,720 | 68,280 |
| 2 | 68,280 | 3,414 | 33,306 | 34,974 |
| 3 | 34,974 | 1,749 | 34,971 | 3 (rounding) |
This method is particularly used where capital invested must be recovered systematically with interest, like leases.
d. Machine Hour Method
This is a usage-based method. Depreciation depends on machine hours worked rather than calendar years.
Example: Machine cost ₹50,000, estimated life 10,000 hours, no residual value. Depreciation rate = ₹5 per hour.
If machine works 2,000 hours in year 1, depreciation = 2,000 × 5 = ₹10,000.
Highly suitable for factories where machines run irregularly and usage varies year to year.
Comparison of Methods
| Method | Depreciation Pattern | Best For |
|---|---|---|
| Straight Line | Equal each year | Buildings, furniture |
| WDV | Higher in early years | Machines, vehicles |
| Annuity | Constant charge (Depreciation+Interest) | Leased assets |
| Machine Hour | Based on usage | Heavy production machinery |
AS-10 Guidelines on Depreciation
As per Accounting Standard (AS) 10: Property, Plant & Equipment:
- Depreciation method must reflect the pattern of future economic benefits.
- Residual value and useful life should be reviewed at least annually.
- Change in method is treated as a change in accounting estimate and applied prospectively.
- Disclosure required: method used, rates applied, and total depreciation charged during the period.
Key Exam-Ready Points
- MCQ Favorite: Straight Line gives equal charge, WDV gives declining charge.
- Numerical Tip: Always subtract residual value before applying SLM.
- True/False: "Machine Hour method is time-based." – False, it is usage-based.
- Case Question: Which method is ideal if asset usage is irregular? – Machine Hour Method.
Depreciation is a critical tool for showing true profits, planning asset replacement, and complying with law. Each method tells a slightly different story about how an asset’s value fades.
Next time you see a factory machine at work, pause for a second and think – "How much value did that machine just lose today?" That’s depreciation in action.