Depreciation Accounting

5.1 Concept and Purpose

Depreciation is the systematic and rational allocation of the depreciable cost (historical cost − salvage value) of a tangible fixed asset over its estimated useful life. It is NOT a cash outflow — it is an accounting entry creating a non-cash expense.

Causes of depreciation:

• Physical deterioration: Wear and tear through use
• Obsolescence: Technological change makes asset unfit before physical end
• Passage of time: Even non-used assets depreciate (lease period, natural decay)
• Depletion: For natural resources (mines, quarries, oil wells)

5.2 Methods of Depreciation

Method 1: Straight-Line Method (SLM)

• Equal depreciation each year = (Cost − Scrap Value) ÷ Useful Life
• Example: Machine cost ₹10 lakh, scrap ₹1 lakh, life 9 years → Annual depreciation = ₹1 lakh/year
• Book value reduces to scrap value at end of life
• Suitable for: Assets used uniformly (furniture, buildings)
• Companies Act 2013, Schedule II — prescribes useful life for SLM/WDV calculations

Method 2: Written Down Value / Diminishing Balance Method (WDV/DBM)

• Fixed % applied to reducing book value each year
• Example: Machine ₹10 lakh, WDV rate 20% → Year 1: ₹2 lakh; Year 2: ₹1.6 lakh (on ₹8 lakh)
• Book value never technically reaches zero (asymptotic)
• Higher depreciation in early years → Higher tax shield initially
• Suitable for: Assets more productive when new; technology assets

Method 3: Units of Production / Machine Hours Method

• Depreciation = (Cost − Scrap) × (Units produced this year ÷ Total estimated units)
• Suitable for: Mining machinery, aircraft engines (measured in flying hours)

Indian tax treatment: Income Tax Act 1961 mandates WDV method for tax depreciation (Section 32). Companies may use SLM for accounting but WDV for tax → creates Deferred Tax differences (Ind AS 12 / AS 22).

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