What is Depreciation and How to Calculate Depreciation?

Meaning of Depreciation

Depreciation means a decrease in value. As and when we use goods, they undergo wear and tear. Thereby their value gets to decrease gradually. Even, through the mere passage of time also, it can lose its value whether put to use or not. This phenomenon of loss in value needs to be added to expenses in books so as to recover the loss from sales.

Definition

Depreciation can be defined as that portion of value which it loses each year due to wear and tear, usage or obsolescence irrespective of whether it is used or not.

It is the process of transferring the cost of the asset into expenses over its lifespan.

Need for charging Depreciation

• As capital is invested in procuring the assets, it needs to be recovered through sale price of your product. So, the depreciation value is added to cost of production in determining the sale price of the product. By charging depreciation, you are recovering the value of the assets proportionately each year throughout their expected lifespan.
• It is needed for replacing the asset on its erosion after the completion of its useful life so as to run the business.

How to calculate Depreciation

Depreciation is normally calculated by spreading 95% value of the asset throughout its estimated lifespan period.

5% value of the asset is kept in books as salvage value which means that you can recover at least 5% value of assets when you sell it in any future years. No asset can be reduced to zero value as it is generally considered that it will fetch you at least a minimum of  5% value of its cost on sale. So only 95% value is written off as depreciation during its lifespan.

There are different methods of calculating depreciation as per practices prevalent in different countries and even in different companies.

Depreciation as per Companies Act 2014

As per Schedule XIV of Indian Companies Act' 1956, depreciation is to be calculated in two methods-

the straight-line method or written down value method.

Under this Companies Act, all assets are grouped into different groups of assets and rates are fixed based on the lifespan of each group of assets. The major classification of assets are as follows:

• Land
• Roads
• Buildings
• Furniture
• Office Equipments
• Vehicles ( Light or Heavy)
• Plant & Machinery

Besides above groupings, there are many subgroupings under each category with some variations in the rates. Further, under Plant & Machinery, calculations are to be made according to a single shift, double shift or triple shift workings at their corresponding rates.

The rate charts are available at Schedule XIV of Companies Act, 1956 (amended in 2014), which get updated as and when changes are made to it.

Straight Line Method of Depreciation

Under the straight-line method of depreciation, depreciation is calculated each accounting year at the same amount as per the Depreciation Rates Schedule of the Companies Act applicable for that Assessment Year. Each accounting year, the depreciation is calculated on the original gross value of the asset. As rates are fixed, the depreciation amount will be the same for each and every accounting year (provided the Gross value of asset remains same and if no additions are made during that year). If additions are made, the amount will increase pro rata.

While making depreciation calculation on additions made during the year, if the addition is made in the first half of the year, the full amount of depreciation will be charged for the whole year on that item.

If the addition is made in the second half of the year, then, only half amount of the depreciation will be charged for that asset in that year.

Illustration for Depreciation Calculated at SLM method

Asset	Value	Rate %	Depreciation (2011-12)	Depreciation  (2012-13)	Depreciation (2013-14)
Building	500000	5	25000	25000	25000
Furniture	100000	10	10000	10000	10000
Machinery	1000000	15	150000	150000	150000
Cars	300000	10	30000	30000	30000

In the above example, no additions are taken. If there is an addition during the year, you will have to provide extra columns for the Addition and Total Value also. Depreciation will be calculated for opening balance and addition separately and the total depreciation will be shown in the depreciation column of that year.

Written Down Value Method of Depreciation (WDV method)

In this method, the depreciation is calculated each accounting year on the net value of the asset. The net value of an asset is that value which gets reduced by its previous amount of depreciation. Each year, you go on deducting the depreciation amount from the value of the asset and then calculate the depreciation on that net amount. So, you will be taking the net value of that asset as your opening balance for calculating the depreciation as opposed to the SLM method, where you always take the original gross value of an asset as your opening balance.

In this method of calculation, the depreciation amount will be higher in the starting years and lower at the end period of the asset. The depreciation rates will be higher in this method but the number of years of asset's life will be the same. Since you are calculating the depreciation on diminishing value basis, the total amount of depreciation charged on any asset during its lifespan will be the same as that charged on SLM method. So, in both methods of SLM method and WDV method, the ultimate residual value will remain more or less the same at the end of its lifespan.

Calculation of Depreciation under WDV method

Asset	Value	Rate %	2011-12 Deprecn.	2011-12 WDV	2012-13 Depr.	2012-13 WDV	2013-14 Depr.
Building	500000	5	25000	475000	23750	453250	22663
Furniture	100000	10	10000	90000	9000	81000	8100
Machinery	1000000	15	150000	850000	127500	722500	108375
Car	300000	10	30000	270000	27000	243000	24300

I hope the concept is clear with the help of above illustrations. You may express your doubts, if any, in the comments section so that I may answer.