What is depreciation?
Depreciation refers to the decrease in the monetary value of physical assets over a period due to wear and tear, regular use, and obsolescence. It is an accounting standard that allocates some portion of the asset cost to the profit and loss (P&L) statement during a financial year over the asset's useful life.
The asset cost reduces as it loses value over the years until it becomes zero or negligible. It happens with most tangible assets, which include computers, buildings, office equipment, plant and machinery, and much more. However, one asset that generally does not depreciate is land, which instead, appreciates over a period.
Important points to know about depreciation
- Companies can depreciate expensive fixed assets over their useful life and spread their costs and generate revenue over the years.
- It represents the difference between the asset’s original cost and the accumulated depreciated value.
- It is accounted at regular intervals to allow companies to move the cost of the assets to the income statement from the balance sheet.
- Businesses can avail of tax deductions for the cost of the assets by reducing the taxable income.
- It is a non-cash charge as there is no actual cash outflow; wherein the initial cost is an actual cash outflow, but the expense is incrementally recorded as the assets provide benefits over a longer period.
What are the different methods to calculate depreciation?
Now that you know what depreciation is, check out six different methods used to calculate it with examples.
Straight-line depreciation method
It is also known as the fixed instalment method and is one of the most commonly used ways of calculation.
In the straight-line depreciation method (SLM), the value of the assets depreciates at a fixed amount for every accounting period until the end of its useful life when the value becomes zero or the salvage price.
The formula for this type of depreciation is as follows:
Straight-line depreciation = (Original value – Salvage Value)/Useful Life
Example: Assume a business buys a machine for INR 1crore with a useful life of 25 years and a salvage value of INR 10 lakhs. The annual amount is calculated as:
SLM depreciation = (10,000,000 – 1,000,000)/25 = 360,000
Units of production method
This method focuses on the amount of activity or work that the asset experiences. Generally, every unit of production has an equal expense, which means its depreciated value is directly linked to the asset’s output capacity.
Therefore, when the usage is high, the asset depreciates at a higher rate and vice versa. Usually, this method for calculating depreciation is used for processing or manufacturing equipment.
The formula for this type of depreciation is given below:
Units of production depreciation = (Number of units produced/Life in number of units) x (Cost – Salvage value)
Example: A company buys a press for INR 50,000 that can print 200,000 flyers over its useful life. The press has a residual value of INR 5,000 and is used to print 5,000 flyers in a year.
Units of production depreciation = (5000/200,000) x (50,000-5,000) = 1,125
Double declining balance depreciation method
It is an accelerated method where the asset is depreciated at a higher rate during the initial years of its useful life.
It is an appropriate method for depreciating assets like laptops and computers that are more productive when they are new.
The formula for this type of depreciation is as follows:
Double declining depreciation = 2 x (straight-line depreciation rate x value at the start of the year)
Example: A company acquires a machine for INR 250,000 with an expected useful life of 10 years. The salvage value is estimated at INR 25,000. Here is the calculation for three years:
SLM depreciation rate = 1/10 = 10%
Double declining balance depreciation:
Year 1 = 2 x (10% x 250,000) = INR 50,000
Year 2 = 2 x ((10% x 250,000-5,000)) = INR 40,000
Year 3 = 2 x ((10% x 200,000-40,000)) = INR 32,000
Annuity method
Most methods do not consider the potential interest lost on the capital cost of the asset. The annuity method eliminates this limitation, and the asset cost is considered as an investment, which is assumed to earn a certain rate of interest.
The interest on the opening balance is debited to the asset account and the cost along with the interest is written off equally over its lifetime.
Example: A company purchases a five-year lease for INR 1,000,000 and the rate of interest is assumed at 4%. The annuity for INR 1 at 4% for five years is 0.275490. The amount written off is:
Annuity depreciation = 1,000,000 x 0.275490 = INR 275,490
Sum of years digits method
This method allocates a higher rate to depreciate the value of the assets in the earlier years. Therefore, it is an accelerated method used for certain types of assets.
The formula for this type of depreciation is:
Sum of digits depreciation = Depreciable cost x (Balance useful life/Sum of years’ digits)
Example: Assume a company purchases a machine for INR 250,000 with an estimated useful life of six years and no salvage value.
Sum of years = 1+2+3+4+5+6 = 21
Year 1 = (250,000-0) x (6/21) = INR 71,428
Year 2 = (250,000-0) x (5/21) = INR 59,523
The amount that is written off every year continues to decrease in this depreciation example as the asset nears the end of its useful life.
Reducing balance method
It is also known as the diminishing balance method and is an accelerated way of depreciating assets. A higher rate is charged during the early years from when the asset is purchased.
During the later years, incrementally smaller rates are applied to calculate the depreciated value of the asset.
The formula for reducing balance method is given below:
Reducing balance depreciation = (Book value at the start of the year x depreciation rate)/100
Example: A company acquires an asset for INR 25 lakhs with a salvage value of INR 5 lakhs and an estimated life of 15 years. The following is the amount written off over three years assuming a rate of depreciation of 15% using this method.
Year 1 = (2,500,000 x 15)/100 = INR 375,000
Year 2 = [(2,500,000 – 375,000) x 15]/100 = INR 318,750
Year 3 = [(2,125,000 – 318,750) x 15]/100 = INR 270,937
Why do assets depreciate over time?
Generally, new assets have a higher value than older assets. The depreciation measures the assets’ loss of value over a period.
The loss in value occurs due to regular usage resulting in wear and tear. It is also affected by the latest technology and products and inflation, which is why assets depreciate over the years.
How are assets depreciated for tax purposes?
There are several types of depreciation methods companies can use to write off the assets. The Income Tax Act, 1961 allows depreciating tangible and amortizing intangible assets over a period.
Any tangible asset used for more than 180 days can be depreciated by 50% of the applicable rate in that year.
This is allowed even if a company purchases an asset and then leases it to another business during the previous year. It is calculated on the reducing balance method on a block of assets.
Companies must take into account the rate at which each block is depreciated as per the income tax guidelines.
Difference between depreciation and amortization
Amortization and depreciation are both used to calculate the value of assets over a period.
It is shown as a business expense in the P&L statement, which reduces the taxable income, and therefore, decreases the tax liability for the businesses.
However, there are some differences between these two, which are listed below:
ParticularsAmortizationDepreciationType of assetsIntangible assetsTangible or fixed assetsMethodOften, straight-line basis where a fixed amount is aamortized over the asset's lifetimeDifferent methods that spread the written down value over the asset’s estimated useful lifeExamplesTrademarks, patents, copyrights, franchise agreementsBuildings, plant and machinery, equipment, vehicles, furniture, and fixturesAccounting for the loss of value of the assets helps companies understand the actual cost of doing business.
To accurately determine a company's profitability, knowing the depreciated value of assets due to wear and tear is important. It also helps businesses understand when the asset needs to be replaced while enabling them to comprehend how much value the assets have lost over a period.
Additionally, it reduces the taxable income as it is a business expense (albeit non-cash), thus decreasing the tax liability of a company.
This is a companion discussion topic for the original entry at https://jupiter.money/resources/guide-to-depreciation/