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In the world of accounting, businesses often invest in assets like machinery, vehicles, or equipment. These assets help generate revenue over several years. However, over time, these assets lose their value due to wear and tear, usage, or obsolescence. This loss in value is called depreciation.
Depreciation is important because it helps businesses allocate the cost of an asset over its useful life, reflecting a more accurate financial position and profit calculation. In this section, we will explore two primary methods of calculating depreciation: the Straight Line Method (SLM) and the Written Down Value Method (WDV).
What is Depreciation? Depreciation is the systematic allocation of the cost of a tangible fixed asset over its useful life. Instead of charging the entire cost of an asset as an expense in the year of purchase, depreciation spreads this cost over the years the asset is expected to be used.
Why is Depreciation Necessary? Without depreciation, profits would be overstated in the year of purchase and understated in later years. Depreciation ensures that expenses match the revenues generated by the asset, following the matching principle in accounting.
Factors Affecting Depreciation:
Depreciable Assets: These are tangible fixed assets like machinery, vehicles, buildings, furniture, etc., which lose value over time.
The Straight Line Method is the simplest and most commonly used method of depreciation. Under SLM, the asset's cost, minus its residual value, is evenly spread over its useful life. This means the depreciation expense remains constant every year.
Formula:
Assumptions: The asset loses value evenly over time, and usage or wear is consistent each year.
| Asset Cost (C) | Residual Value (S) | Useful Life (N) years | Annual Depreciation (D) |
|---|---|---|---|
| Rs.1,00,000 | Rs.10,000 | 5 | Rs.(1,00,000 - 10,000) / 5 = Rs.18,000 |
The Written Down Value Method, also known as the reducing balance method, charges depreciation on the asset's book value (also called written down value) at the beginning of each year. Since the book value decreases every year, the depreciation expense also decreases over time.
Formula for Depreciation in Year t:
Formula for Book Value after Depreciation:
| Year | Opening Book Value (Rs.) | Depreciation @ 20% (Rs.) | Closing Book Value (Rs.) |
|---|---|---|---|
| 1 | 50,000 | 10,000 | 40,000 |
| 2 | 40,000 | 8,000 | 32,000 |
| 3 | 32,000 | 6,400 | 25,600 |
Step 1: Identify the values:
Step 2: Apply the SLM formula:
\[ D = \frac{C - S}{N} = \frac{1,00,000 - 10,000}{5} = \frac{90,000}{5} = 18,000 \]
Answer: Annual depreciation expense is Rs.18,000 every year for 5 years.
Step 1: Year 1 depreciation:
\[ D_1 = 20\% \times 50,000 = 0.20 \times 50,000 = 10,000 \]
Book value at end of Year 1:
\[ BV_1 = 50,000 - 10,000 = 40,000 \]
Step 2: Year 2 depreciation:
\[ D_2 = 20\% \times 40,000 = 8,000 \]
Book value at end of Year 2:
\[ BV_2 = 40,000 - 8,000 = 32,000 \]
Step 3: Year 3 depreciation:
\[ D_3 = 20\% \times 32,000 = 6,400 \]
Book value at end of Year 3:
\[ BV_3 = 32,000 - 6,400 = 25,600 \]
Answer: Depreciation for years 1, 2, and 3 are Rs.10,000, Rs.8,000, and Rs.6,400 respectively. Book values at the end of each year are Rs.40,000, Rs.32,000, and Rs.25,600.
Step 1: Calculate residual value:
\[ S = 10\% \times 80,000 = 8,000 \]
Annual depreciation:
\[ D = \frac{80,000 - 8,000}{4} = \frac{72,000}{4} = 18,000 \]
| Year | Depreciation (Rs.) | Book Value End of Year (Rs.) |
|---|---|---|
| 1 | 18,000 | 80,000 - 18,000 = 62,000 |
| 2 | 18,000 | 62,000 - 18,000 = 44,000 |
| 3 | 18,000 | 44,000 - 18,000 = 26,000 |
| 4 | 18,000 | 26,000 - 18,000 = 8,000 |
Depreciation rate = 25%
| Year | Opening Book Value (Rs.) | Depreciation @ 25% (Rs.) | Closing Book Value (Rs.) |
|---|---|---|---|
| 1 | 80,000 | 20,000 | 60,000 |
| 2 | 60,000 | 15,000 | 45,000 |
| 3 | 45,000 | 11,250 | 33,750 |
| 4 | 33,750 | 8,438 | 25,312 |
Comparison: SLM charges a fixed Rs.18,000 every year, while WDV charges a reducing amount starting at Rs.20,000 and decreasing each year. The book value under SLM reaches the residual value exactly at the end of 4 years, while WDV book value remains above residual value, reflecting a more conservative approach.
Depreciation is an expense and reduces the asset's book value. The accounting entry involves:
Journal Entry:
Depreciation Expense A/c &
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