DEPRECIATION - BASICS

Depreciation means a reduction in the value of an asset over time due to wear and tear.

Concept of Depreciation

Fixed assets are held on a long term basis and used to generate periodic revenue. That portion of
assets, which is believed to have been consumed or expired to earn the revenue, needs to be charged
as cost. Such an appropriate proportion of the cost of fixed assets is called Depreciation.

Business enterprises require fixed assets for their business operations such as furniture and fixtures,
office equipment’s plant and machinery, motor vehicles, land and building etc. In the process of
converting Raw material into finished products, the fixed assets depreciate in value over a period of
time, i.e. its useful life.

In other words, the process of allocation of the cost of a fixed asset over its useful life is known as
depreciation.

Methods of Providing Depreciation

The two main methods of calculating depreciation are:

1. Straight Line Method or Original Cost Method: Under this method, depreciation is charged
at fixed percentage on the original cost of the asset, throughout its estimated life. Thus, the
amount of depreciation is uniform from year to year. That is why this method is also known
as ‘Fixed Instalment Method’ or Equal instalment method’.

The amount of depreciation can be easily calculated by the following formula:

Original Cost – Estimated scrap value

Depreciation =
Estimated life in Years

Here, Estimated Scrap Value refers to an estimated value of asset after it has come to the end
of its useful life.

2. Diminishing balance method or Written Down Value Method: Under this method,
depreciation is charged as a fixed percentage on the book value of the asset every year.

Hence, in Straight Line method, amount of depreciation is same but in Diminishing Balance
Method amount of depreciation goes on decreasing every year.

Depreciation can be recorded by crediting it to the Assets account.

Apart from the above methods, depreciation is also calculated on Units of Production methods
wherein depreciation is calculated based on the total number of hours used or the total number of
units to be produced by using the asset, over its useful life.

The above referred methods of depreciation can easily be understood by the following example:

Example:
Suppose a manufacturing company purchases a machinery for Rs. 1,00,000 and the useful life of the
machinery are 10 years and the residual value of the machinery is Rs. 20,000. The said machine can
produce 10,000 units of a product in its entire life. Rate of Depreciation is 10%.
Units produced year wise are
Year 1 2 3 4 5 6 7 8 9 10
Units 1500 1400 1300 1200 1100 1000 900 750 500 350

Solution:
Straight Line Diminishing Units of Production
Method Balance Method Method
Original Cost 80,000.00 1,00,000.00 80,000.00
1 8000 10,000 12000
2* 8000 9,000 11200
3 8000 8,100 10400
4 8000 7,290 9600
5 8000 6,561 8800
6 8000 5,905 8000
7 8000 5,314 7200
8 8000 4,783 6000
9 8000 4,305 4000
10 8000 3,874 2800

Working Note: Calculation of Amount of Depreciation for Year 2

Diminishing Balance
Year Straight Line Method Units of Production Method
Method
*2 (1,00,000-20,000) (1,00,000-10,000)*10% (1,00,000-20,000)*1400
= 8000 =11200
10 = 9,000/- 10,000

Accounting Treatment of Depreciation

Once depreciation has been computed using any one of the above methods, it must be bought to
books. Generally, accounting entries for depreciation is made at the end of the Financial Year through
Depreciation A/c. The amount of depreciation is debited by crediting Fixed Assets account i.e.

Depreciation A/c……..Dr
To Fixed Asset A/c

The effect of this entry is that the Depreciation account show the amount of expense for the year
while the fixed asset account shows a reduced balance. Depreciation account, being a nominal
account, gets closed at the end of every financial year by transferring its balance to Profit & Loss A/c.

Example:
ABC Ltd. Bought a Motor Vehicle for Rs. 75,000/- on 01.04.2017. The said company plans to provide
depreciation at 20% per year on diminishing balance method. Show the following accounts in his
ledger for 2018, 2019 and 2020.
- Motor Vehicle Account
- Depreciation Account
- Relevant portion of Profit & Loss A/c

Solution:

Dr. Motor Vehicle A/c Cr.

Date Particulars Amount Date Particulars Amount
01-04-2017 Bank 75,000.00 31-03-2018 Depreciation 15,000.00
Balance c/d 60,000.00
75,000.00 75,000.00
 01-04-2018 Balance b/d 60,000.00 31-03-2018 Depreciation 12,000.00
Balance c/d 48,000.00
60,000.00 60,000.00

01-04-2019 Balance b/d 48,000.00 31-03-2019 Depreciation 9,600.00

Balance c/d 38,400.00
48,000.00 48,000.00

Dr. Depreciation A/c Cr.

Date Particulars Amount Date Particulars Amount
31-03-2018 Motor Vehicle 15,000.00 31-03-2018 Profit & Loss A/c 15,000.00
15,000.00 15,000.00

31-03-2019 Motor Vehicle 12,000.00 31-03-2019 Profit & Loss A/c 12,000.00
12,000.00 12,000.00

31-03-2020 Motor Vehicle 9,600.00 31-03-2020 Profit & Loss A/c 9,600.00
9,600.00 9,600.00

Dr. Profit & Loss A/c (Extract) Cr.

Date Particulars Amount Date Particulars Amount
31-03-2018 Depreciation 15,000.00

31-03-2019 Depreciation 12,000.00

31-03-2020 Depreciation 9,600.00

Working Note – Calculation of Depreciation to be charged every year

Year Opening Book Value Depreciation Closing Book Value
2018 75,000/- 15,000/- 60,000/-
2019 60,000/- 12,000/- 48,000/-
2020 48,000/- 9,600/- 38,400/-

Note:
1. Salvage value is not considered in Diminishing Balance Method because book value of an asset
does not get Zero in Diminishing Balance Method (since depreciation is calculated as a
percentage on opening book value of the asset) and therefore depreciation is charged till the
time the written down value of the asset reaches its salvage value.

2. Original Cost of an asset shall include the cost incurred on installation of the asset.

3. In case, an asset has been acquired at any time during the financial year then depreciation is
calculated from the date of acquisition of the asset.