Depreciation

What is Depreciation?

Depreciation is when the worth of something tangible gradually decreases over its life. This might occur due to regular wear and tear, use, or becoming outdated. Businesses apply this simple accounting principle to determine how much something will cost them depending on how long they believe they will be utilizing it.

Why is Depreciation Important?

• Effective Financial Disclosure: Depreciation allows companies to report on their balance sheet the actual value of their assets.
• Tax savings: depreciation is treated as a cost, and this reduces the tax liability of the company.
• Budgeting and Planning: Companies can prepare for future repair or replacement by knowing how much assets will depreciate.

Depreciation Methods

There are various methods to calculate depreciation. These are most commonly used:

1. SLM (Straight-Line Method)

• Most basic method, where the same depreciation is accounted for each year.
• Formula = (Cost of Asset−Salvage Value)/Useful Life of Asset
• For example: Suppose a machine is costing 10 lakh rupees, its scrap value will be 1 lakh rupees, and will last for 10 years. Each year, ₹90,000 would be debited towards depreciation.

2. The Written Down Value (WDV) Method

• A fixed amount is added to a book value of the asset every year to account for depreciation.
• Depreciation = Book Value x Depreciation Rate
• When applying this method, you pay higher depreciation in the initial years and lower depreciation in subsequent years.

3. Units of the Method of Production

• Depreciation is calculated depending on how much the asset has been used or produced.
• It applies to assets whose depreciation is dependent on usage and not time.

4. The Sum of the Years' Digits Method

• Another quicker method of devaluation in which it declines quicker at first and quicker in the future.

Rate of Depreciation Based on Indian Laws

The Income Tax Act of 1961 and the Companies Act of 2013 define depreciation in India. When companies calculate depreciation for income tax purposes and for reporting purposes, there are some guidelines that they must abide by.

• The Income Tax Act: In the case of most assets, the Written Down Value (WDV) method is employed.
• Companies Act: The Companies Act permits companies to select between the Straight-Line Method and the WDV Method.

Examples of Depreciation

1. An entity invests ₹5 lakh on a vehicle for which it shall be utilizing its services for a period of 5 years. According to the Straight-Line Method, its annual loss will be ₹1 lakh.
2. By the WDV method, its loss would reveal that the car lost 20% of value in the very first year that is, ₹1 lakh (20% of ₹5 lakh).

Key Points to Remember

• Depreciation spreads out the cost of an object over its useful life.
• It avoids paying taxes by lowering income that is taxed.
• It is important to understand depreciation in order to make accurate financial reports and plans.