One of the basic principles of an accrued accounting system is matching revenue with expenses. When a company buys assets such as building, plant and machinery, the cost is capitalized in an account. These assets are used over their useful life in the production of revenue. To match revenue with expenses for a period, management spread the cost of the assets over its useful life by charging depreciation every year.
Suppose that in the year 2018, a company has purchased a plant worth Rs. 50,00,000 which has an expected useful life of 10 years. In this case the accountant has two options;
- Assign the entire cost of the plant Rs 50,00,000 to expenses in the year 2016, or
- Spread the cost of the plant over its expected useful life.
In the first case, if you assign the whole cost of Rs 50,00,000 as expenses in the year 2018, it will distort reported income as the entire cost will be used over the useful life of 10 years. This type of accounting will not be following the basic matching principle.
Over the period of 10 years, plants are consumed or worn out in the creation of products. Every item produced in the company takes out a small portion of the value of the plant. Therefore, the best approach is to spread the cost of the asset over its expected useful life of 10 years. To do this, you need to calculate depreciation for the year in which it’s used or put to use.
Estimated or expected useful life is the projected period of time over which an asset is expected to have productive or continuing value to its owner. Cost of acquiring assets must be allocated over this estimated useful life.
Depreciation is a non-cash item charged to the income statement as expenses to match the resulting revenue of the year. In simpler terms, it’s the allocation of cost to match revenue and expenses.
Here are examples of certain type of assets on which depreciation is charged;
- Office building
- Factory building
- Plants
- Machinery
- Furniture and fixtures
- Computers
- Office equipment
Please note, land is not subject to depreciation as it has no expected life term. This means land is assumed to have an unlimited useful life.
How to determine the amount of depreciation
To calculate depreciation on a particular asset, you require three estimates;
- asset’s useful life,
- its salvage value, and
- the method of allocation to be employed
Following two methods of allocating cost of asset over the useful life is used;
- Straight line method
- Written down value method
Straight line method
In the straight line method, the company depreciates the asset by a uniform amount each year. For instance, if an asset costs Rs 55,00,000 has an expected life of 10 years, estimated salvage value of Rs 5,00,000, then depreciation by using straight line method will be Rs 5,00,000 per year. Its calculated below;
(Cost of the asset – Salvage value) / useful life = (55,00,000-5,00,000)/10 = Rs. 5,00,000
Let us take another example, a vehicle costs Rs. 1,00,000 and is expected to last 10 years. Using the straight line method, Rs. 10,000 will be charged each year into the income statement as depreciation. The balance of Rs. 90,000 (Rs. 1,00,000 – Rs. 10,000) will be shown on the balance sheet under the head fixed asset.
Here is the straight line method formula:
Depreciation = (Cost of the asset – Salvage Value) / useful life of the asset
Written down value method (WDV)
In a written down value method, you charge more depreciation at a fixed rate in the early years of the asset’s life and correspondingly less in following years. This means, in initial years you charge more compared to less in later years.
Every year, depreciation has to be calculated on the last year’s closing written down value.
Let us understand how to calculate depreciation in a written down value method with the help of the following example.
For instance if your rate of depreciation as per income tax act is 40% and the value of computer purchased is Rs 60,000, then for the first year, your depreciation will be Rs 24,000 (60000*40%), the closing written down value of the computer will be Rs 36,000. In the 2nd year, you need to calculate it on Rs 36,000 not on the original cost of Rs 60,000, which comes to Rs. 14,400. Closing WDV for the 2nd Year will be Rs. 21,600 (Rs 36,000-Rs 14,400).
Here is the formula to calculate the rate of depreciation in percentage:
1-(residual value/Cost of the asset)^1/useful life of the asset}*100
Lets calculate it with the following details;
- Cost of the asset = 25,00,000
- Salvage value = 2,50,000
- Useful life = 11 years
You can use this formula for any type of assets. Better use Microsoft Excel to get accurate results.
In this case, rate of depreciation = {1-(2,50,000/25,00,000)^1/11}*100 = 18.88%
You have to charge 18.88% per year on the opening written down value of the assets i.e. Rs 25,00,000 for the first year.
Businesses depreciate fixed assets for both income tax and accounting purposes. For accounting purposes business has liberty in calculating the useful life, salvage value as per the companies act 2013. Companies act 2013 has specified useful life of certain types of assets based on which rate of depreciation has to be calculated.
However, for tax purposes business must depreciate assets according to the tax rules.
Example Showing how depreciation is calculated by using WDV method
- Cost of the asset = 90,000
- rate of depreciation = 40%
Formula to calculate Depreciation = (costs – accumulated depreciation)* rate of depreciation
Depreciation for four accounting years is calculated by using above information:
- Year 1: (Rs 90,000 – 0) * 40% = Rs 36,000
- Year 2: (Rs 90,000 – Rs 36,000)*40% = Rs 21,600
- Year 3: (Rs 90,000 – Rs 36,000 – Rs 21,600)*40% = Rs 12,960
- Year 4: (Rs 90,000-Rs 36000 – Rs 21,600 – Rs 12,960)*40% = Rs 7,776
How depreciation is accounted in company’s books of accounts
At the time of purchasing fixed assets, you need to debit the respective asset account and credit cash/bank/vendor account as the case may be. In this case both the accounts are balance sheet items. There will not be any impact on the income statement.
Based on the depreciation amount calculated on the assets (in general WDV used except in a few industries where straight line is used), you need to debit the depreciation account and credit accumulated depreciation account. In this case, you will charge depreciation to the income statement as an expense for the period.
Accumulated depreciation is shown in the balance sheet by reducing the historical cost of fixed assets. You need to depreciate the asset until the accumulated depreciation equals the original cost of the asset. Amount shown in this accumulated account at a point of time represents the total decrease in the value of the assets.
