Concept and Meaning of Depreciation

From sole proprietorship to large multi-national corporations, all businesses have to take the concept of depreciation into account while carrying out their regular commercial ventures. Its principles apply to accounting, auditing, costing and taxation. Before we go on to its nuances, it is pertinent to understand the basic meaning of depreciation.

Meaning of Depreciation

The monetary values of all tangible assets tend to reduce gradually over time due to factors like wear and tear. The meaning of depreciation, in very simple words, is the rate at which this value drops. Hence, it compares an asset’s current value with its original cost at the time of acquisition or purchase.

For example, let us consider a cloth manufacturing company that purchased a truck in 2010 for Rs. 50 lakh for the purpose of transportation of finished goods to its dealers. The truck’s value will decrease each year with regular use over time. In order to determine the true reduced value of its truck every year, the company will deduct, say, 10% of its worth. This is the meaning of depreciation.

Depreciation applies to all tangible and generally fixed assets whose values decrease with time. These include buildings, vehicles, machinery, office equipment, furniture, etc. Land, however, does not come under this list because the value of land usually only increases; it reduces only during adverse economic downturns.

Causes of Depreciation

The most important cause of depreciation is regular wear and tear, but it is certainly not the only one. The following causes can reduce the value of an asset:

• Wearing out
• Consumption or other loss of value arising from usage
• Effluxion of time
• Obsolescence through technology
• Market changes

Purpose of Calculating Depreciation

Depreciation has wide-ranging implications in the field of accounting and taxation. Let us understand why.

• Depreciation in accounting: The applicability of depreciation to accounting is based on the matching principle, under which the cost of the asset is matched with the value it generates during the course of its useful life. In order to determine their real cost, the values of assets are reduced during every accounting year and are written off as expenses.

• Depreciation in taxation: Taxation laws allow depreciation to be deducted when tax liabilities are calculated because the depreciated value of an asset is written off as an expense under accounting. Consequently, under the Income Tax Act, 1961, assets can be depreciated at the rates prescribed.

The main purposes of calculating depreciation are:

• Measuring income or loss generated from assets
• Determining the real value of assets
• Ascertaining true expenditure incurred in the production
• Availing tax benefits and deductions

After understanding the meaning of depreciation and its nuances, let us now further see how accounting of depreciation happens.

Accounting of Depreciation

Since depreciation is charged directly against assets, the journal entry for the same involves Depreciation A/c and the relevant Asset A/c. We have to debit Depreciation A/c because it is an expense or loss, while we credit Asset A/c as its value diminishes.

Date	Particulars		Amount (Dr)	Amount (Cr)
	Depreciation A/c	Dr	XXX
	To Asset A/c			XXX
	(Being asset depreciated by Rs. XXX)

Sometimes, a provision may be made for accumulated depreciation, under which total depreciation is calculated up to a specific date, instead of it being computed in each accounting year. The balance sheet explains this as a deduction from gross fixed assets.

Calculation of Depreciation 

There are four common methods of calculating depreciation of assets.

1] Straight Line Method

Straight line method is the simplest way to calculate depreciation. Under this mode, the amount of value reduced from the original cost of the asset remains constant for every accounting year. For example, if we assume the rate of depreciation for a car worth Rs. 10 lakhs to be constant at Rs. 25,000, then its value will reduce by Rs. 25,000 in every accounting year during the course of its useful life.

2] Double-declining balance method

This method of calculating depreciation is based on the presumption that since the productivity of assets falls with time, its rate of depreciation also should be more in the beginning and reduce gradually over time. This method counts the expense incurred by depreciation as twice the book value of the asset for each accounting year.

3] Written down value method

Also known as Diminishing Balance Method. Under this method, the percentage rate of depreciation remains fixed, but we have to reduce the asset’s value during every accounting year. The Income Tax Act, 1961 has prescribed this method for calculation of depreciation.

4] Units of production method

Units of Production Method considers an asset’s productivity and life while computing depreciation, hence, it applies generally to machines, equipment, and vehicles only. Depreciation is based on the total number of units produced or hours put to use by the asset.

Solved Example for You

Question: LMN Pvt. Ltd. purchased a truck in 2005 for Rs. 20 lakhs. The expected useful life of the truck is 5 years, during which period its value will diminish by 10% per annum. Calculate its depreciation for the year and show accounting entries for the same.

Answer: Since the question has only mentioned a fixed rate of depreciation, we have to use the straight-line method.

Depreciation amount = 10% of Rs. 20,00,000 = Rs. 2,00,000.

Date	Particulars		Amount (Dr)	Amount (Cr)
	Depreciation A/c	Dr	2,00,000
	To Truck A/c			2,00,000
	(Being Truck A/c depreciated by Rs. 2,00,000)