In accounting terms, depreciation is defined as the reduction of
recorded cost of a fixed asset in a
systematic manner until the value of the asset becomes zero or negligible.
An example of fixed assets are buildings, furniture, office
equipment, machinery etc.. A land is the only exception which cannot be
depreciated as the value of land appreciates with time.
Depreciation allows a portion of the cost of a fixed asset to the
revenue generated by the fixed asset. This is mandatory under the matching
principle as revenues are recorded with their associated expenses in the
accounting period when the asset is in use. This helps in getting a complete
picture of the revenue generation transaction.
An example of Depreciation – If a delivery truck is purchased a
company with a cost of Rs. 100,000 and the expected usage of the truck are 5
years, the business might depreciate the asset under depreciation expense as
Rs. 20,000 every year for a period of 5 years.
In accounting terms, depreciation is defined as the reduction of
recorded cost of a fixed asset in a systematic manner until the value of the
asset becomes zero or negligible. The monetary value of an asset decreases over
time due to use, wear and tear or obsolescence. This decrease is measured as
depreciation. An example of fixed assets are buildings, furniture, office
equipment, machinery etc.. A land is the only exception which cannot be
depreciated as the value of land appreciates with time.
How to calculate depreciation in small business?
There three
methods commonly used to calculate depreciation. They are:
1. Straight line
method
2. Unit of
production method
3. Double-declining
balance method
Three main inputs are required to calculate
depreciation:
1. Useful life –
this is the time period over which the organisation considers the fixed asset
to be productive. Beyond its useful life, the fixed asset is no longer
cost-effective to continue the operation of the asset.
2. Salvage value
– Post the useful life of the fixed asset, the company may consider selling it
at a reduced amount. This is known as the salvage value of the asset.
3. The cost of
the asset – this includes taxes, shipping, and preparation/setup expenses.
Unit of
production method needs the number of units used during production. Let’s take
a look at each type of Depreciation method in detail.
Why
do we charge depreciation?
We charge depreciation because most of the long-lived assets used
in abusiness have 1) a significant cost, and 2) they will be useful only for
alimited number of years. The matching principle (a basic underlying accounting
principle) requires that the actual cost of these assets be allocated to the
accounting periods in which the company will benefit from their use.
Types of depreciation
1) Straight-line depreciation method
This is the simplest method of all. It involves simple allocation
of an even rate of depreciation every year over the useful life of the asset.
The formula for straight line depreciation is:
Annual
Depreciation expense = (Asset cost – Residual Value) / Useful life of the asset
OR
Depreciation Expense = (Cost of the asset – Salvage value) /
Useful life
·
Cost of the asset is the purchase price of the asset
·
Salvage value is the value of the asset at the end of its useful
life
·
Useful life of asset represents the number of periods in which the
asset is expected to be used by the company
Example – Suppose a manufacturing company purchases a machinery for Rs.
100,000 and the useful life of the machinery are 10 years and the residual
value of the machinery is Rs. 20,000
Annual Depreciation expense = (100,000-20,000) / 10 = Rs. 8,000
Thus the company can take Rs. 8000 as the depreciation expense
every year over the next ten years as
shown in depreciation table below.
Year
|
Original cost – Residual value
|
Depreciation expense
|
1
|
Rs.
80000
|
Rs.
8000
|
2
|
Rs.
80000
|
Rs.
8000
|
3
|
Rs.
80000
|
Rs.
8000
|
4
|
Rs.
80000
|
Rs.
8000
|
5
|
Rs.
80000
|
Rs.
8000
|
6
|
Rs.
80000
|
Rs.
8000
|
7
|
Rs.
80000
|
Rs.
8000
|
8
|
Rs.
80000
|
Rs.
8000
|
9
|
Rs.
80000
|
Rs.
8000
|
10
|
Rs.
80000
|
Rs.
8000
|
2) Unit of Production method
This is a two-step process, unlike
straight line method. Here, equal expense rates are assigned to each unit
produced. This assignment makes the method very useful in assembly for
production lines. Hence, the calculation is based on output capability of the
asset rather than the number of years.
The
steps are:
Step
1: Calculate per unit depreciation:
Per unit Depreciation = (Asset cost –
Residual value) / Useful life in units of production
Step
2: Calculate the total depreciation of actual units produced:
Total Depreciation Expense = Per Unit
Depreciation * Units Produced
Example: ABC
company purchases a printing press to print flyers for Rs. 40,000 with a useful
life of 1,80,000 units and residual value of Rs. 4000. It prints 4000 flyers.
Step
1: Per unit Depreciation = (40,000-4000)/180,000 = Rs. 0.2
Step
2: Total Depreciation expense = Rs. 0.2 * 4000 flyers = Rs. 800
So the total Depreciation expense is Rs. 800 which is accounted.
Once the per unit depreciation is found out, it can be applied to future output
runs.
3) Double declining method / Written Down
Value Method (WDV) Depreciation
This is one of the two common methods a company uses to account
for the expenses of a fixed asset. This is an accelerated depreciation method.
As the name suggests, it counts expense twice as much as the book value of the
asset every year.
It is also known as Reducing Balance or Reducing Installment
Method or Diminishing Balance Method. Under this method, the depreciation is
calculated at a certain fixed percentage each year on the decreasing book value
commonly known as WDV of the asset (book value less depreciation).
Depreciation = 2 * Straight line depreciation
percent * book value at the beginning of the accounting period
Book value = Cost of the asset – accumulated
depreciation
Accumulated
depreciation is the total depreciation of the fixed asset accumulated up to a
specified time.
Example: On
April 1, 2015, company X purchased an equipment for Rs. 100,000. This is
expected to have 5 useful life years. The salvage value is Rs. 14,000. Company
X considers depreciation expense for the nearest whole month. Calculate the
depreciation expenses for 2015, 2016, 2017 using a declining balance method.
Useful life = 5
Straight line depreciation percent = 1/5 = 0.2 or
20% per year
Depreciation rate = 20% * 2 = 40% per year
Depreciation for the year 2015 = Rs. 100,000 * 40% *
9/12 = Rs. 30,000
Depreciation for the year 2016 = (Rs. 100,000-Rs.
30,000) * 40% * 12/12 = Rs. 28,000
Depreciation for the year 2017 = (Rs. 100,000 – Rs. 30,000 – Rs.
28,000) * 40% * 9/12 = Rs. 16,800
Depreciation table is shown below:
Year
|
Book
value at the beginning
|
Depreciation
rate
|
Depreciation
Expense
|
Book
value at the end of the year
|
2015
|
Rs.
100000
|
40%
|
Rs.
30,000 * (1)
|
Rs.
70,000
|
2016
|
Rs.
70000
|
40%
|
Rs.
28,000 * (2
|
Rs.
42,000
|
2017
|
Rs.
42,000
|
40%
|
Rs.
16,800 * (3)
|
Rs.
25,200
|
2018
|
Rs.
25,200
|
40%
|
Rs.
10,080 * (4)
|
Rs.
15,120
|
2019
|
Rs.
15,120
|
40%
|
Rs.
1,120 * (5)
|
Rs.
14,000
|
Depreciation for 2019 is Rs. 1,120 to keep the book value same as
salvage value.
Rs. 15,120 – Rs. 14,000 = Rs. 1,120 (At this point the
depreciation should stop).
Why should small businesses care to
record depreciation?
So now we know the meaning of
depreciation, the methods used to calculate them, inputs required to calculate
them and also we saw examples of how to calculate them. Let’s find out as to
why the small businesses should care to record depreciation.
As we already know the purpose of
depreciation is to match the cost of the fixed asset over its productive life
to the revenues the business earns from the asset. It is very difficult to
directly link the cost of the asset to revenues, hence, the cost is usually
assigned to the number of years the asset is productive.
Over the useful life of the fixed
asset, the cost is moved from balance sheet to income statement. Alternatively,
it is just an allocation process as per matching principle instead of a
technique which determines the fair market value of the fixed asset.
Accounting
entry – DEBIT depreciation expense account and CREDIT accumulated depreciation
account.
If we do not use depreciation in
accounting, then we have to charge all assets to expense once they are bought.
This will result in huge losses in the following transaction period and in high
profitability in periods when the corresponding revenue is considered without
an offset expense. Hence, companies which do not use the depreciation expense
in their accounts will incur front-loaded expenses and highly variable
financial results.
Depreciation
Rates for Financial Year 2019-20 & Assessment Year 2020-21
Sl. No.
|
Asset
Class
|
Asset
Type
|
Rate of
Depreciation
|
1
|
Building
|
Residential buildings not including boarding
houses and hotels
|
5%
|
2
|
Building
|
Boarding houses and hotels
|
10%
|
3
|
Building
|
Purely temporary constructions like wooden
structures
|
100%
|
4
|
Furniture
|
Any fittings / furniture including
electrical fittings
|
10%
|
5
|
Plant and machinery
|
Motor cars excluding those used in a
business of running them on hire
|
15%
|
6
|
Plant and
|
MachineryLorries/taxis/motor buses used in a
business of running them on hire
|
30%
|
7
|
Plant and machinery
|
Computers and computer software
|
60%
|
8
|
Plant and machinery
|
Books owned by assessee carrying on a
profession being annual publications
|
100%
|
9
|
Plant and machinery
|
Books owned by assessee carrying on
profession not being annual publications
|
60%
|
10
|
Plant and machinery
|
Books owned by assessee carrying on business
in running lending libraries
|
100%
|
11
|
Intangible assets
|
Franchise, trademark, patents, license,
copyright, know-how or other commercial or business rights of similar nature
|
25%
|
