What is Depreciation and How to Calculate Depreciation?

Definition and Meaning of Depreciation

Depreciation means a decrease in value. As and when we use goods, they undergo wear and tear. Thereby, their value begins decreasing gradually. Even with the passage of time alone, they can lose their value, whether put to use or not. This notion of loss in value needs to be added to expenses in the accounting books to recover/adjust the loss from sales.

Definition:

Depreciation is the portion of value that an asset loses each year due to wear and tear, usage, or obsolescence, irrespective of whether it is used.

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 the sale price of your product. But it is a known fact that whenever you sell assets, they fetch lower prices. 
• So, the depreciation value is to be added to the 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. If the asset is sold within its lifespan, the difference between the remaining value of the asset and its sale proceeds is treated as a loss on sale of assets. 
• The written-off cost serves as an offset needed while replacing the asset after the completion of its useful life so as to project a good picture. 

How to calculate Depreciation

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

5% of the asset value is kept in books as salvage value, which supposes that you can recover at least 5% of the asset when you sell it in any future years. No asset can be reduced to zero value, as it is generally considered that it has some value even after complete erosion.

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

In this article, I am dealing with the calculation as per the Companies Act in India

Depreciation as per Companies Act 2014 (Schedule XIV of 1956)

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

Either the straight-line method or the written-down value method.

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

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

Besides the above groupings, there are many subgroupings under each category with some variations in the rates. 

Further, under Plant & Machinery, calculations are to be made based on their single shift, double shift or triple shift workings using their corresponding rates.

The rate charts are available at Schedule XIV of the 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 the asset remains the same and if no additions are made during that year). If additions are made, the amount will increase pro rata.

While making depreciation calculations 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, only half the 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 example above, no additions are included. If there is an addition during the year, you will need to add additional columns for Addition and Total Value. Depreciation will be calculated separately for the opening balance and the addition, and the total depreciation will be shown in the depreciation column for that year.

Written Down Value Method of Depreciation (WDV method)

In this method, depreciation is calculated each accounting year based on the asset's net value. The net value of an asset is the amount remaining after subtracting its accumulated depreciation. Each year, you deduct the depreciation amount from the asset's value and then calculate depreciation on that net amount. So, you will be taking the asset's net value as your opening balance for calculating depreciation, as opposed to the SLM method, where you always take the asset's original gross value as your opening balance.

In this method of calculation, the depreciation amount will be higher in the beginning 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 the asset's life will be the same. 

Since you are calculating the depreciation on a diminishing value basis, the total amount of depreciation charged on any asset during its lifespan will be the same as that charged on the SLM method. 

So, in both methods, 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 the above illustrations. You may express your doubts, if any, in the comments section so that I can clear them.