Definition of Depreciation
Depreciation is a term used to describe the decrease in value of an asset over time. It is an accounting technique to spread the expense of the asset over its useful life. Depreciation showcases the exact used asset’s value. It enables businesses to compare the cost of assets to the revenue generated from such assets.
An accountant records depreciation for all capitalised assets that have not yet been fully depreciated at the end of an accounting period. The entry in the journal includes a debit for the depreciation expense to the income statement and credit to the accumulated depreciation appearing in the balance sheet.
The simplest method for keeping track of depreciation is the straight-line method. In this, the cost of the asset, less the salvage value, is divided by the asset's entire useful life, resulting in an equal annual depreciation expense.
Depreciation per annum = (Cost of an Asset - Residual Value)/Useful life of an Asset
An accelerated depreciation approach is the declining balance method. This method involves calculating the depreciation by applying the straight-line depreciation % on the asset's book value (i.e., cost less accumulated depreciation). The same percentage results in a more considerable depreciation expenditure in the early years, reducing yearly because an asset's carrying value was higher earlier.
Depreciation per annum = (Net Book Value - Residual Value) * %Depreciation Rate
Double-Declining Balance (DDB)
Another technique for calculating depreciation is the double-declining balance (DDB) method. Here the rate of depreciation is twice the straight-line depreciation % and is applied on the asset's book value. As a result, it moves along roughly twice as quickly as the declining balance technique.
DDB = (Net Book Value - Salvage Value) / Useful Life * (2 times the depreciation rate).
Sum-of-the-Years Digits (SYD)
Accelerated depreciation is also possible using the sum-of-the-years' digits (SYD) approach. Start by adding up all the asset's projected lifespan digits. So, for example, the asset’s projected lifespan is 3 years, and the sum of the years' digits would be: 3 + 2 + 1 = 6. Each digit is then divided by this sum to arrive at the percentage by which the asset would be depreciated each year, starting with the highest number in year 1.
Units of Production
An estimate of the overall units an asset will create over its useful life is needed for this procedure. The depreciation cost is then computed annually based on the units produced. Finally, this approach calculates depreciation costs based on the output generation of the asset.
Which assets are subject to depreciation?
Owned by you
Serve your business or generate income
Have a predetermined functional life
Expect it to endure longer than a year.
Benefits of Charging for Depreciation
Depreciation is a tax-deductible expense, so it should be considered in order to determine the correct tax liability. Depreciation must be calculated in the financial statement as per the Companies Act, 2013. For tax purposes, depreciation is calculated as per the provisions of the Income Tax Act, 1961.
Where depreciation expenditure is not considered, the profit may appear relatively high, particularly in industries requiring a lot of gear and equipment. This could lead to a significant redistribution of profits to shareholders, leaving the business short on cash when it needs to repair an asset.