CA Foundation – Accounting
Depreciation
1. Simple Explanation
Depreciation is the systematic allocation of an asset’s cost over its useful life.
- It recognises the wear‑and‑tear or obsolescence of a long‑term asset.
- The expense is recorded each year in the income statement, while the asset’s carrying amount (book value) is reduced in the balance sheet.
Why it matters – It matches the cost of an asset to the revenue it helps generate, ensuring a realistic picture of profitability and asset value.
2. Key Points
| # | Concept | What to remember |
|---|---|---|
| 1 | Cost of the asset | Purchase price + all costs necessary to bring the asset to a usable condition (installation, delivery, testing). |
| 2 | Useful life | Expected period (in years or units) the asset will be productive. |
| 3 | Residual (salvage) value | Expected value at the end of useful life. |
| 4 | Depreciation methods | Straight‑line, reducing‑balance, units of production, sum‑of‑the‑years‑digits. |
| 5 | Depreciation expense | Expense recognized each period. |
| 6 | Book value (carrying amount) | Cost – accumulated depreciation. |
| 7 | Depreciation in accounting vs tax | Different rules may apply for financial reporting and tax purposes. |
| 8 | Journal entry | Dr. Depreciation Expense / Cr. Accumulated Depreciation. |
| 9 | Capitalisation criteria | If cost > ₹5,000 (or as per company policy), treat as a depreciable asset. |
| 10 | Re‑assessment | Useful life or residual value can be revised if circumstances change. |
3. Depreciation Methods
| Method | Formula | When to use | Pros | Cons |
|---|---|---|---|---|
| Straight‑Line (SL) | ((C - R) / \text{Useful life}) | Most common, when asset’s benefit is uniform. | Simple; predictable expense. | Ignores actual usage. |
| Reducing‑Balance (RB) | (\text{Book value at start} \times \text{Rate}) | Assets that lose value quickly (e.g., technology). | Matches higher expense early. | Expense declines rapidly; may under‑recognise later costs. |
| Units of Production (UoP) | ((C - R) \times \frac{\text{Units produced}}{\text{Total expected units}}) | When usage varies (machines, vehicles). | Matches cost to actual usage. | Requires accurate measurement of usage. |
| Sum‑of‑the‑Years’ Digits (SYD) | ((C - R) \times \frac{\text{Remaining years}}{\text{Sum of years}}) | Similar to RB but with a different rate schedule. | Accelerated expense early; simple math. | Less intuitive than RB. |
Example rate for RB:
For a 5‑year asset with 20% RB:
Year 1: 20 % of cost, Year 2: 20 % of (cost – depr. year 1), …
4. Worked Example
Scenario
A company purchases a machine for ₹ 2,00,000.
- Installation & delivery cost: ₹ 20,000
- Total cost (C = ₹ 2,20,000)
- Useful life: 5 years
- Residual value: ₹ 20,000
- Depreciation method: Straight‑Line
4.1 Calculate Annual Depreciation
[ \text{Depreciation expense} = \frac{C - R}{\text{Useful life}} = \frac{₹ 2,20,000 - ₹ 20,000}{5} = \frac{₹ 2,00,000}{5} = ₹ 40,000 \text{ per year} ]
4.2 Record Journal Entries
| Year | Debit | Credit |
|---|---|---|
| 1 | Dr. Depreciation Expense ₹ 40,000 | Cr. Accumulated Depreciation ₹ 40,000 |
| 2 | Dr. Depreciation Expense ₹ 40,000 | Cr. Accumulated Depreciation ₹ 40,000 |
| … | … | … |
| 5 | Dr. Depreciation Expense ₹ 40,000 | Cr. Accumulated Depreciation ₹ 40,000 |
4.3 Book Value at End of Year 5
[ \text{Book value} = C - \text{Accumulated Depreciation} = ₹ 2,20,000 - ₹ 2,00,000 = ₹ 20,000 ]
This matches the residual value, completing the depreciation schedule.
Alternate Example – Reducing‑Balance
Same asset, but using 20 % RB.
| Year | Book Value at Start | Depreciation | Accumulated Depreciation | Book Value End |
|---|---|---|---|---|
| 1 | ₹ 2,20,000 | 20 % × ₹ 2,20,000 = ₹ 44,000 | ₹ 44,000 | ₹ 1,76,000 |
| 2 | ₹ 1,76,000 | 20 % × ₹ 1,76,000 = ₹ 35,200 | ₹ 79,200 | ₹ 1,40,800 |
| 3 | ₹ 1,40,800 | 20 % × ₹ 1,40,800 = ₹ 28,160 | ₹ 107,360 | ₹ 1,12,640 |
| 4 | ₹ 1,12,640 | 20 |