What is Depreciation?
In Accounts, Depreciation can be defined as the method of allocating the cost of a physical asset over its useful life or the time period it is to be used for. In simple words, depreciation is the reduction in the value of an asset due to the passage of time, normal wear and tear and obsolescence. Depreciation is generally regarded as a non-cash expenditure and helps companies to reduce their taxable income. Here, we will study methods of depreciation and how to calculate depreciation.
Methods of Depreciation and How to Calculate Depreciation
In Accounting, there are various methods for calculating depreciation. A company can adopt any of these methods of calculating depreciation depending on its needs. Some of the methods for calculating depreciation are:
Straight-line method
Written down Value method
Annuity method
Sinking Fund method
Production Unit method
So let us study the methods of calculating depreciation in detail.
Straight-line Method
The straight-line method of depreciation is the most simple and easy to use depreciation method. It is the most commonly used method of depreciation. It is also called the Original cost method, Fixed Installment method or Equal Installment method. Under this method, the depreciation calculation is done by deducting the residual value from the Cost of the asset and then the amount is divided by the number of years the asset was used for or its useful life. The same amount of depreciation is charged every year on the original cost of the asset. The amount of depreciation is charged to the Profit and Loss Account every year. For better understanding, we have given the straight-line depreciation formula.
Straight-line Method Formula is:
Depreciation Formula: \[\frac{\text{Cost of Asset - Residual Value}}{\text{Useful life of the asset}}\]
Depreciation Rate Formula: \[\frac{\text{Amount of Depreciation}}{\text{Original Cost of the Asset}}\] X 100
Written Down Value Method
The written down value method also known as diminishing balance method or reducing balance method is a method of calculating depreciation in which a fixed percentage of depreciation is charged on the reducing value of the asset every year. While calculating depreciation in the diminishing balance method, the salvage value of the asset is not taken into consideration. The amount of depreciation decreases every year under this method. The diminishing depreciation method is calculated by the formula:
Depreciation, reducing balance method: \[\frac{\text{Rate of Depreciation}}{\text{100}}\] X Book Value
Calculation of depreciation rate under diminishing balance method: 1- (s/c)\[^{\frac{1}{n}}\] X 100
Where s is the scrap value of the asset
c is the cost of the asset and n is the useful life of the asset.
Some companies or organizations also use the double-declining balance method, which results in a large amount of depreciation expense. Double declining balance method is a type of diminishing balance method in which the depreciation factor is 2X than the straight-line method.
Double Declining Balance Method Formula:
Depreciation = 2 X SLDP X BV
Where SLDP is Straight-line Depreciation Percentage
BV is Book Value
Annuity Method
The annuity method of depreciation calculates depreciation on the asset by calculating its rate of return. This method considers the asset as an investment. It takes into consideration the internal rate of returns on the cash outflows and inflows of the asset.
Depreciation cost formula under the annuity method is:
Depreciation = (Cost of the Asset - Residual Value) X Annuity factor
Sinking Fund Method
The Sinking fund method of depreciation is a method of calculating depreciation where enough amount is accumulated at the end to replace the asset at the end of its useful life. Here the amount of depreciation is charged to a sinking fund account which is invested in various government bonds and securities. The interest earned from these securities is used to replace the asset.
Sinking Fund Depreciation Method Formula:
Depreciation Value Formula: (Cost of the asset - Residual value) X Present value of Rs. 1 at sinking fund tables for a given rate of interest
Production Unit Method
The Production unit method takes into consideration the number of units that the machine has produced in a year. The depreciation cost depends on how much the machine or asset has been used over a year. The amount of depreciation formula under this method is:
Depreciation = \[\frac{\text{Estimated Total Cost - Residual Value}}{\text{Estimated Total Output}}\] X Actual Output during the year.
Features of Depreciation and the Methods
Every asset has only a timely use. And with that, the value has declined accordingly. So the measure of declination of asset value over the period is calculated with depreciation. And the following methods; straight-line method, written down value method, production unit method, annuity method, sinking fund method have their features making the depreciation process unique.
The major features of depreciation are listed below:
By the usage, obsolescence or time that have passed, there is a loss of value occurred for the assets. And it is included in it.
The booked value of fixed assets that have affected a declination is what depreciation is.
Depreciation is a continuous process until the useful life period of the asset.
We must deduct the cost of expiration, that is depreciation before calculating the taxable profit.
It doesn’t involve cash flow. Hence it can be called a non-cash expense.
The loss measured must be constant and gradual.
In depreciation, maintenance cannot be included.
Depreciation Objectives For Providing
If we have closely checked, the term ‘depreciation’ has two different meanings. As a common term that is generalized, the word depreciation means the decline of the value of property over time. However, in accounting ‘depreciation’ is the expiration cost of the fixed asset. And the assets we mentioned here are physical assets except for land. All other assets do have only a limited period of usefulness.
Assets are used for generating income till their economic value. So that must be allocated and it is done smoothly using the depreciation method. And this is considered the primary objective.
The Need of Providing Depreciation
The amount accumulated as profit during the useful period of the asset can be used for the replacement after its expiration period.
The capital amount should be secured without affecting the period of inflation in the economy. So it must be well planned.
In a way, true profit obtained as a result of this asset is to be taken as the business expenditure. To ascertain that we can use depreciation.
As depreciation is considered a statutory need. It must be calculated accordingly before the profits are shared in dividends.
Just like any other concept, depreciation methods also have got their benefits. As already said, depreciation is the expense of a business. So we can check it with calculated depreciation as they both are matching ones. After calculation of depreciation, we get the tax benefits and also the replacement cost too.
FAQs on Methods of Depreciation: A Quick Guide
1. What are the two primary methods of depreciation prescribed in the CBSE Class 11 Accountancy syllabus?
For CBSE Class 11 students, the two primary methods for calculating depreciation are:
- Straight-Line Method (SLM): Also known as the Original Cost Method, where a fixed amount of depreciation is charged every year throughout the asset's useful life.
- Written Down Value (WDV) Method: Also known as the Diminishing Balance Method, where depreciation is charged at a fixed percentage on the reduced book value of the asset each year.
2. What is the fundamental difference between the Straight-Line Method (SLM) and the Written Down Value (WDV) Method?
The main difference lies in the basis of calculation. In the Straight-Line Method, depreciation is calculated on the original cost of the asset, resulting in a constant depreciation amount each year. In contrast, the Written Down Value Method calculates depreciation on the book value (cost minus accumulated depreciation) of the asset, which leads to a decreasing amount of depreciation over time.
3. What are the three key factors needed to calculate the amount of depreciation for an asset?
To determine the depreciation amount, you need to consider three essential factors:
- The Cost of the Asset: This includes the purchase price and all expenses incurred to make the asset ready for use, such as installation charges and freight.
- The Estimated Useful Life of the Asset: This is the period over which the asset is expected to be used by the business.
- The Estimated Scrap or Residual Value: This is the expected value of the asset at the end of its useful life.
4. Why is the Straight-Line Method considered the simplest method for calculating depreciation?
The Straight-Line Method is considered the simplest because it applies a uniform charge for depreciation every financial year. The calculation is straightforward: (Cost of Asset - Scrap Value) / Useful Life. This consistency makes it easy to apply, understand, and predict, without the need for complex year-on-year recalculations of the asset's base value.
5. How does the choice of depreciation method impact a company's reported profit?
The choice of method significantly impacts reported profits, especially in the early years of an asset's life. Using the WDV method results in higher depreciation expenses initially, which leads to lower reported profits and lower tax liability. Conversely, the SLM method leads to lower, stable depreciation expenses, resulting in higher reported profits in the early years compared to WDV. Over the asset's entire life, however, the total depreciation charged is the same regardless of the method used.
6. Why is depreciation not charged on land?
Depreciation is an expense allocated for assets that have a finite or limited useful life due to wear and tear, usage, or obsolescence. Land is considered to have an unlimited useful life and does not get consumed or worn out. In fact, its value typically appreciates over time. Therefore, according to accounting principles, land is not subject to depreciation.
7. For which type of assets is the Written Down Value method more suitable than the Straight-Line Method?
The Written Down Value method is more suitable for assets that are highly productive and generate more revenue in their early years, with efficiency declining over time. Examples include machinery, vehicles, and electronic equipment. This method aligns with the matching principle by allocating a larger portion of the asset's cost to the periods when it contributes most to revenue generation.
8. Can a business change its method of depreciation from WDV to SLM?
Yes, a business can change its method of depreciation, but it is not done arbitrarily. A change is permissible only if it is required by a statute, an accounting standard, or if the change will result in a more appropriate presentation of the financial statements. This is considered a change in accounting policy and must be disclosed in the financial records, along with its financial impact, to ensure transparency for stakeholders.
9. What is the importance of providing for depreciation in accounting?
Providing for depreciation is crucial for several reasons:
- To Ascertain True Profit: It ensures that the cost of using an asset is matched against the revenue it helps generate, leading to a more accurate calculation of net profit or loss.
- To Show a True and Fair View: It reflects the correct value of fixed assets in the balance sheet, preventing overstatement.
- To Accumulate Funds for Replacement: It allows a company to retain a portion of its profits to systematically save for replacing the asset at the end of its useful life.
- To Comply with Legal Requirements: The Companies Act and tax laws mandate the charging of depreciation.
