What is Depreciation – Definition, Methods and Calculation Formula ? how to calculate depreciation using straight line method (SLM), reducing balance or written down value method ? Depreciation can be defined as the reduction in value of a fixed asset due to usage, wear and tear, passage of time, new technology or market changes. Depreciation is allocated in each accounting year during the expected useful life of asset until the value of asset becomes zero or negligible. Fixed assets include building, plants and machinery, furniture and fixtures, vehicles, computers, office equipment and other fixed assets that are used in business for revenue generation. Here fixed asset excludes land which cannot be depreciated, because the value of land appreciates with time.
Example – If a company purchases a machinery with a cost of ₹1,50,000/- and the expected useful life of the machine is 5 years. The company might depreciate the value of the machine under Depreciation Expense as ₹30,000/- every year for a period of five years.
Methods of Calculating Depreciation
The two most common methods to calculate depreciation are –
- Straight Line Method (SLM)
- Reducing Balance or Written Down Value (WDV) Method
Each of the methods should be applied only after considering nature of the asset, type of asset and circumstances of prevailing business. The Straight Line Method (SLM) is the most suitable and accurate method to provide depreciation in most cases. The Income Tax Rules prescribe the reducing balance method instead of the straight line method except in the case of assets of an undertaking engaged in generation and distribution of power.
Straight Line Method
The Straight Line Method (SLM) is also known as Original Cost Method, Fixed Percentage Method and Fixed Installment Method. Under this method, an equal amount of depreciation is written off every year during the expected useful life of the asset. The formula to calculate depreciation under this method is –
[Depreciation = (Total Cost of Asset – Scrap Value) / Expected Useful Life of Asset in Years]
Straight Line Depreciation Example – A manufacturing company purchases a machinery for ₹1,50,000/- and the estimated useful life of the machine is 6 years and the salvage value of the machinery is ₹30,000/-
Depreciation (under SLM) = (1,50,000 – 30,000) / 6 = ₹20,000/-
Thus, the company can write off ₹20,000/- as the depreciation expense every year over the next 6 years.
Reducing Balance Method or Written Down Value (WDV) Method
The Reducing Balance Method is also known as the Written Down Value Method (WDV Method), Diminishing Value Method, Reducing Installment Method and Fixed Percentage on Diminishing Balance Method. Under this method, depreciation is written off over the useful life of an asset at a fixed percentage every year on the reducing value. The value of depreciation decreases from year to year. This method is mostly used for plant and machinery, fixtures etc.
Example – A manufacturing company purchases a machinery for ₹1,00,000/- and the rate of depreciation is 20%.
For 1st Year – Depreciation will be 20% of 1,00,000 i.e., ₹20,000/-
For 2nd Year – Depreciation will be 20% of (1,00,000 – 20,000) i.e., ₹16,000/-
For 3rd Year – Depreciation will be 20% of (1,00,000 – 20,000 – 16000) i.e., ₹12,800/-
And so on…as shown in following table.
Rate of Depreciation to applied in case of Written own Value Method can be calculated using the following formula :
Comparison between the Straight Line Method and Reducing Balance Method
Calculation of Depreciation
In the Straight Line Method, depreciation is calculated on the original cost of the asset.
In the Reducing Balance Method, depreciation is calculated on the written down value (i.e. Cost minus Depreciation) of the asset.
Amount of Depreciation
In the Straight Line Method, the amount of depreciation remains fixed during the estimated useful life of the asset.
In the Reducing Balance Method, the amount of depreciation reduces year after year.
Value of Asset
In the Straight Line Method, the book value of the asset can be reduced to nil or to its residual value.
In the Reducing Balance Method, the book value never gets reduced to zero.
Impact on Profit Loss Account
In the Straight Line Method, total charges (i.e. depreciation plus repair) is less during initial years but in later years, total charges increases as repairs increase.
In the Reducing Balance Method, total charges remain constant as in initial years repair expenses are less and depreciation is higher while in later years, depreciation decreases and repair increases.
The Straight Line Method is suitable for the assets like trademarks, patents, copyrights, because these assets give almost equal utility in terms of productivity during the estimated useful life of assets.
The Reducing Balance Method is suitable for assets which give higher utility in the initial years like machinery etc.