Depreciation

In short

Depreciation is the systematic allocation of the depreciable amount of a tangible fixed asset over its useful life — it is a charge against profit for the wearing out, consumption or loss of value of an asset used in business, not a method of valuing the asset or of saving cash. It matters because without it profit is overstated, the balance sheet shows assets at an unrealistic figure, and the matching concept is broken. In India the rules come from AS 10 (Property, Plant and Equipment) / Ind AS 16, Schedule II of the Companies Act, 2013 (useful lives), and separately Section 32 of the Income-tax Act, 1961 (block of assets, WDV). It is a guaranteed scoring area in B.Com exams, and appears in placement tests of audit firms, banks, NBFCs and shared-service centres (Deloitte, EY, Genpact, WNS, TCS, Infosys BPM) as journal entries, asset-schedule and profit-on-sale sums.

Explained

Meaning, causes and objectives

• Depreciation - the systematic allocation of the depreciable amount (cost less residual value) of an asset over its useful life. It is an *expense*, charged whether or not the firm earns a profit.
• Causes: (i) wear and tear through use, (ii) efflux of time (even idle assets age), (iii) obsolescence — new technology or changed demand, (iv) depletion of wasting assets (mines, quarries), (v) accident or permanent fall in utility, (vi) expiry of legal rights (lease, patent).
• Objectives: show true profit (match cost of using an asset with the revenue it helps earn); show a true and fair balance sheet; retain funds in the business for replacement; comply with law (Companies Act requires it before declaring dividend); correct cost ascertainment for pricing.
• Related words: Depletion - wasting natural resources; Amortisation - intangibles (patents, copyrights, software) and leases; Dilapidation - damage to leased property; Obsolescence - becoming out of date; Depreciation is not a provision for repairs or for replacement cost.
• Depreciation is a non-cash charge: it reduces profit but no cash leaves. Hence it is added back in the cash flow statement (operating activities, indirect method) and when computing funds from operations.

Three key estimates and what is depreciable

• Cost (historical cost): purchase price + non-refundable duties + freight, insurance in transit, installation, erection, trial-run cost, professional fees, and estimated dismantling/site-restoration cost. Under GST, input tax credit availed is not capitalised; if ITC is not available (e.g. blocked credit) the GST becomes part of cost.
• Residual (scrap/salvage) value: estimated amount recoverable at the end of useful life, net of disposal cost. Schedule II allows residual value not more than 5% of original cost unless a higher figure is justified and disclosed.
• Useful life: period over which the asset is expected to be available for use (or units of output). Not the same as physical life.
• Land is not depreciated (indefinite life); leasehold land is amortised over the lease period. Buildings on land are depreciated.
• Depreciable amount = Cost − Residual value. Depreciation begins when the asset is ready for use and continues until it is sold, discarded or fully depreciated (in Ind AS 16, it does not stop merely because the asset is idle).

Methods of providing depreciation

1. Straight Line Method (SLM) / fixed instalment / original cost method — equal charge each year. Suited to assets whose utility is uniform (buildings, furniture, leases, intangibles). Simple; asset can be reduced exactly to residual value; but repairs rise with age, so total cost of use (depreciation + repairs) is uneven.
2. Written Down Value (WDV) / Diminishing or Reducing Balance Method — a fixed percentage on the opening book value, so the charge falls every year. Suited to plant and machinery, vehicles, computers. Matches heavy early benefit with heavy early charge; depreciation + repairs stay fairly level; book value never becomes zero; needed for Income-tax.
3. Sum of Years' Digits (SYD) — depreciable amount × (remaining life ÷ sum of digits of life). An accelerated method giving a declining charge without the WDV formula.
4. Annuity method — treats the asset as an investment; the annual charge is a constant annuity that recovers cost *plus* interest on capital locked up. Used for long leases.
5. Depreciation Fund (Sinking Fund) method — a fixed sum charged to P&L each year is invested outside the business; on maturity the investments are sold to buy the new asset. Provides cash for replacement.
6. Insurance policy method — a similar idea, but the annual premium is paid to an insurance company which pays an agreed sum at the end.
7. Machine Hour Rate method — depreciation per hour of running; charge = rate × hours used. Used where machine use varies.
8. Production / units-of-output method — depreciable amount ÷ estimated total units × units produced.
9. Depletion method — for mines and quarries: cost ÷ estimated total quantity of mineral × quantity extracted.
10. Revaluation (appraisal) method — for loose tools, packing cases, livestock: depreciation = opening value + purchases − closing valuation.

Accounting treatment and journal entries

• Method 1 — charge to the asset account (no provision): depreciation is credited directly to the asset; the Fixed Asset a/c shows written-down value.
  • Depreciation A/c Dr. / To Asset A/c; then Profit & Loss A/c Dr. / To Depreciation A/c.
• Method 2 — provision for depreciation (accumulated depreciation) account: the asset stays at cost; depreciation accumulates separately and is shown as a deduction in the balance sheet. This is the method companies use.
  • Depreciation A/c Dr. / To Provision for Depreciation A/c; P&L A/c Dr. / To Depreciation A/c.
  • On sale: open an Asset Disposal A/c — debit it with cost, credit it with accumulated depreciation on that asset and with sale proceeds; the balance is profit (credit) or loss (debit) transferred to P&L.
• Depreciation on additions and sales during the year: charge pro rata for the period of use (the Companies Act/Schedule II basis). Many exam questions instead say "charge for full year on all assets held at the year end" — follow the question's instruction and state the assumption.
• Profit on sale is really a reversal of excess depreciation and is credited to P&L (under Schedule III it is shown as other income; a material loss is an expense).
• Revaluation under Ind AS 16: if the revaluation model is used, the surplus goes to Other Comprehensive Income / Revaluation Surplus, and later depreciation is computed on the revalued amount.

Indian standards, Companies Act and Income-tax

• AS 10 (revised) "Property, Plant and Equipment" (which absorbed the old AS 6 on depreciation) and Ind AS 16 require: depreciation of each significant component separately (component accounting, mandatory for companies from FY 2015-16); review of useful life, residual value and method at least at each financial year end.
• Change of method or estimate: under AS 10 / Ind AS 16 a change in method, useful life or residual value is a change in accounting estimate — applied prospectively over the remaining life; no retrospective recomputation. (The older AS 6 treatment, which required retrospective recomputation with the difference charged in the year of change, is still asked in many university papers — answer per the syllabus followed and name the standard.)
• Companies Act, 2013, Section 123: depreciation as per Schedule II must be provided before declaring dividend. Schedule II prescribes indicative useful lives (not rates) — e.g. general plant and machinery 15 years, factory building 30 years, non-factory building 60 years, furniture and fittings 10 years, motor cars 8 years, computers (end-user devices) 3 years and servers 6 years. A company may use a different life/residual value if justified by technical advice and disclosed in the notes.
• Schedule II allows SLM, WDV or the units-of-production method; for assets costing up to ₹5,000 the earlier 100%-write-off rule applied under the Companies Act, 1956, and is not carried into Schedule II (immaterial items are handled by the company's capitalisation policy).
• Income-tax Act, Section 32: depreciation is allowed on the block of assets at prescribed WDV rates (broadly 10% buildings, 15% plant and machinery, 40% computers and software, 40% certain pollution-control and energy-saving devices; rates are capped at 40% since AY 2018-19 and can change — verify the current Appendix I rates). Additional depreciation 20% (35% in notified backward areas) on new plant and machinery for manufacturers under s.32(1)(iia). Assets put to use for less than 180 days in the year of acquisition get half the normal depreciation. Depreciation is mandatory (allowed even if not claimed, since AY 2002-03).
• Because book (Schedule II) and tax (s.32) depreciation differ, a timing difference arises → deferred tax under AS 22 / Ind AS 12.
• Ind AS 36 impairment: if the recoverable amount falls below the carrying amount, an impairment loss is recognised — separate from, and in addition to, depreciation.

Key points

• Depreciation - systematic allocation of the depreciable amount of a tangible asset over its useful life; an expense, not a valuation.
• Depreciable amount - cost (or revalued amount) less residual value.
• Useful life - expected period of availability for use; Schedule II gives indicative lives, not rates.
• SLM - equal annual charge; rate = (Cost − Scrap)/(Life × Cost) × 100; book value can reach residual value exactly.
• WDV - fixed % on opening book value; falling charge; book value never reaches zero; the Income-tax basis.
• Non-cash charge - reduces profit without cash outflow; added back in cash flow from operations.
• Land - never depreciated; leasehold land - amortised over lease term.
• Provision for depreciation method - asset shown at cost, accumulated depreciation deducted separately in the balance sheet.
• Asset Disposal A/c - cost debited, accumulated depreciation and sale proceeds credited; balance is profit or loss.
• Profit on sale - excess depreciation charged earlier; credited to P&L, not to capital reserve.
• Change in method/life/residual value - a change in accounting estimate under AS 10 / Ind AS 16; applied prospectively.
• Component accounting - significant parts with different useful lives depreciated separately; mandatory for companies.
• Section 123, Companies Act 2013 - depreciation per Schedule II must be provided before declaring dividend.
• Section 32, Income-tax Act - block of assets, WDV rates, half rate if put to use under 180 days, mandatory allowance.
• Deferred tax - arises because book and tax depreciation differ (AS 22 / Ind AS 12).
• Depletion / amortisation / impairment - wasting assets / intangibles and leases / fall in recoverable amount respectively.
• Sinking fund method - charge invested outside the business so cash is available for replacement.
• Machine hour and production methods - link the charge to actual usage rather than time.

Formulas and examples

Example 1 — SLM, pro-rata, and sale with a provision account. A firm buys a machine on 1 April 2023 for ₹4,70,000 and spends ₹30,000 on installation. Scrap value ₹50,000, useful life 5 years, SLM, year ends 31 March. On 1 October 2026 the machine is sold for ₹1,90,000.

• Cost = 4,70,000 + 30,000 = ₹5,00,000; depreciable amount = 5,00,000 − 50,000 = ₹4,50,000; annual depreciation = 4,50,000/5 = ₹90,000.
• 2023-24: 90,000 · 2024-25: 90,000 · 2025-26: 90,000 · 2026-27 (1 Apr–1 Oct = 6 months): 90,000 × 6/12 = 45,000.
• Accumulated depreciation to date of sale = 90,000 × 3 + 45,000 = ₹3,15,000; book value = 5,00,000 − 3,15,000 = ₹1,85,000.
• Sale proceeds ₹1,90,000 → profit on sale ₹5,000 (credited to P&L).
• Entries in 2026-27: Depreciation A/c Dr. 45,000 / To Provision for Depreciation A/c 45,000; Machinery Disposal A/c Dr. 5,00,000 / To Machinery A/c 5,00,000; Provision for Depreciation A/c Dr. 3,15,000 / To Machinery Disposal A/c 3,15,000; Bank A/c Dr. 1,90,000 / To Machinery Disposal A/c 1,90,000; Machinery Disposal A/c Dr. 5,000 / To P&L A/c 5,000.

Example 2 — WDV versus SLM on the same asset. Cost ₹1,00,000, life 4 years, scrap ₹10,000. SLM charge = (1,00,000 − 10,000)/4 = ₹22,500 p.a. WDV rate from scrap: r = 1 − (10,000/1,00,000)^1/4 = 1 − 0.1^0.25 = 1 − 0.5623 = 43.77% (use 43.77%).

Both recover ₹90,000; WDV front-loads the charge (₹43,770 against ₹22,500 in year 1), so early-year profits are lower and later profits higher. (Closing figures are rounded to the rupee; the ₹3 difference is rounding.)

Example 3 — change in method / estimate, applied prospectively (AS 10 · Ind AS 16). A company bought plant on 1 April 2022 for ₹12,00,000, residual ₹1,20,000, life 10 years, SLM. Annual charge = (12,00,000 − 1,20,000)/10 = ₹1,08,000. On 1 April 2026, after four completed years (2022-23, 2023-24, 2024-25, 2025-26), the accumulated depreciation = 1,08,000 × 4 = ₹4,32,000, carrying amount = ₹7,68,000. On 1 April 2026 the remaining useful life is reassessed at 4 years and residual value at ₹68,000.

• New annual charge = (7,68,000 − 68,000)/4 = ₹1,75,000 per year from 2026-27 onwards.
• No entry is passed for earlier years — the change is an estimate change, applied prospectively, and is disclosed in the notes.

Example 4 — Income-tax block of assets, half-rate rule (s.32). Opening WDV of the plant and machinery block (15%) on 1 April 2026 = ₹20,00,000. A new machine costing ₹6,00,000 is purchased and put to use on 1 December 2026 (less than 180 days). An old machine is sold for ₹2,50,000.

• Block = 20,00,000 + 6,00,000 − 2,50,000 = ₹23,50,000.
• Full-rate portion = 23,50,000 − 6,00,000 = 17,50,000 → 15% = ₹2,62,500.
• Half-rate portion = 6,00,000 → 7.5% = ₹45,000.
• Total depreciation allowable = ₹3,07,500; closing WDV = 23,50,000 − 3,07,500 = ₹20,42,500. (No individual profit/loss on the sale — it is absorbed in the block. Additional depreciation under s.32(1)(iia), if the assessee is eligible, would be 20% of ₹6,00,000, restricted to 10% this year and the balance 10% next year; rates should be verified against the current Appendix I.)

Example 5 — machine hour rate and units of production. A machine costs ₹8,00,000, scrap ₹50,000, estimated life 15,000 running hours; it runs 2,400 hours in the year.

• Rate = (8,00,000 − 50,000)/15,000 = ₹50 per hour; depreciation = 50 × 2,400 = ₹1,20,000.
• If instead the estimate is 3,00,000 units of output and 48,000 units are produced: D = 7,50,000 × 48,000/3,00,000 = ₹1,20,000 — the same answer because usage is proportionate in both measures.

Where it is used

• Audit and assurance (Big Four, Indian CA firms): vouching the fixed asset register, testing Schedule II lives, component accounting, impairment and depreciation recomputation during statutory audit.
• Finance and accounts / shared-service centres (Genpact, WNS, Infosys BPM, Accenture): running the fixed-asset module in SAP FI-AA, Oracle or Tally — capitalisation, asset master, depreciation runs, retirements and transfers.
• Taxation and compliance roles: block-of-assets computation for ITR, tax audit (Form 3CD clause on depreciation), deferred tax workings, and transfer-pricing cost build-ups.
• Project and manufacturing finance (Tata Steel, L&T, Maruti, cement and power plants): capital cost allocation, machine hour rates for costing and quotation, replacement planning and WDV-based insurance cover.
• Banking, NBFC and leasing (HDFC, Bajaj Finance, Sundaram Finance): depreciation in borrower financials for EBITDA and DSCR, asset-backed loan security valuation, and lease accounting under Ind AS 116.
• Regulated tariffs: electricity and infrastructure regulators (CERC, state ERCs) allow depreciation as a tariff component, so its rate directly affects tariffs.

Interview questions

• Q: Is depreciation a source of funds? A: No. It is a non-cash expense; it is added back in the cash flow statement only because it was deducted from profit — it generates no cash by itself, though retaining the charge in the business conserves funds.
• Q: Why is land not depreciated? A: Its useful life is considered indefinite, so there is no depreciable amount to allocate; leasehold land, however, is amortised over the lease term, and a building standing on land is depreciated.
• Q: SLM or WDV — which gives higher profit in the early years? A: SLM, because WDV charges more depreciation in the early years; over the full life both charge the same total.
• Q: How is profit on sale of a fixed asset explained? A: It means depreciation charged in earlier years exceeded the actual fall in value; it is credited to the Profit and Loss Account, shown as other income.
• Q: Does Schedule II of the Companies Act, 2013, prescribe rates? A: No — it prescribes indicative useful lives and a residual value normally capped at 5% of cost; the company derives its own rate and may deviate with technical justification and disclosure.
• Q: How do you treat a change in the method of depreciation under AS 10 / Ind AS 16? A: As a change in accounting estimate, applied prospectively over the remaining useful life, with disclosure; no retrospective restatement (the older AS 6 approach required retrospective recomputation).
• Q: What is component accounting? A: Significant parts of an asset with different useful lives are identified and depreciated separately — for example an aircraft engine or a furnace lining apart from the main asset.
• Q: Why do book and tax depreciation differ, and what does that create? A: Schedule II uses useful lives asset-wise while s.32 uses WDV rates on a block of assets; the timing difference creates a deferred tax asset or liability under AS 22 / Ind AS 12.
• Q: An asset is idle for the whole year — do you still charge depreciation? A: Yes under Ind AS 16, since depreciation continues until the asset is derecognised; it stops only if the asset is classified as held for sale (Ind AS 105).
• Q: Difference between depreciation and impairment? A: Depreciation is the planned allocation of cost over useful life; impairment is an unplanned write-down when the recoverable amount falls below the carrying amount (Ind AS 36 / AS 28).
• Q: Can a company pay dividend without providing depreciation? A: No — Section 123 of the Companies Act, 2013, requires depreciation as per Schedule II to be provided before declaring dividend.
• Q: How would you depreciate a mine? A: By the depletion method — cost allocated in proportion to the quantity of mineral extracted against the total estimated reserves.

Common mistakes

• Charging a full year's depreciation on mid-year purchases or disposals when the question (or the Companies Act) requires pro-rata — and not stating the assumption used.
• Applying the WDV percentage to original cost instead of the opening book value, or applying the SLM rate to the reducing balance.
• Forgetting to deduct residual value before dividing by life in SLM (and wrongly deducting it in WDV, where the rate already accounts for it).
• Taking the profit on sale to capital reserve or netting it against the asset account instead of crediting the Profit and Loss Account.
• Crediting depreciation to the asset account while the question specifies a Provision for Depreciation account (or mixing both in one answer), and omitting the Asset Disposal Account on sale.
• Treating a change in method retrospectively under current AS 10 / Ind AS 16, or quoting withdrawn AS 6 as live law.
• Mixing up the Companies Act and Income-tax computations in one schedule, and ignoring the half-rate rule for assets put to use for under 180 days.

Related topics

Final accounts · Company accounts and Ind AS basics · Key Ind AS standards explained · Journal, ledger and trial balance · Hire purchase and instalment accounting · Accounting principles and the accounting cycle