Depreciation and it's Accounting

Depreciation and it's Accounting: A Detailed Summary 

1. Introduction to Depreciation

Depreciation is a key concept in accounting that represents the gradual reduction in the value of tangible fixed assets over time. This decline is due to factors such as wear and tear, usage, or obsolescence. Depreciation is crucial for accurate financial reporting as it impacts both the balance sheet and the income statement.

2. Purpose of Depreciation

The main purposes of depreciation are:

• Expense Matching: Depreciation spreads the cost of an asset over its useful life, matching expenses with the revenue generated by the asset. This aligns with the accrual accounting principle.
• Asset Valuation: It provides a more realistic value of the asset on the balance sheet.
• Tax Benefits: Depreciation reduces taxable income, as depreciation expense is deductible for tax purposes.

3. Depreciation Methods

Different methods are used to calculate depreciation, each affecting financial statements in various ways:

• Straight-Line Method: This method allocates an equal amount of depreciation expense each year over the asset’s useful life. It is the most straightforward and widely used method.

• Formula: $\text{Depreciation Expense}=\frac{\text{Cost of Asset}-\text{Residual Value}}{\text{Useful Life}}$

• Example: For a machine costing ₹10,000 with a residual value of ₹1,000 and a useful life of 9 years, the annual depreciation expense would be $\frac{10,000 - 1,000}{9} = 1,000 \text{ per year}$
  

• Reducing Balance Method: This method applies a fixed percentage to the reducing balance (or book value) of the asset each year, resulting in higher depreciation expenses in the earlier years and lower expenses in later years.

• Formula: $\text{Depreciation Expense}=\text{Book Value at Beginning of Year}\times \text{Depreciation Rate}$

• Example: For an asset with a cost of ₹10,000, a residual value of ₹500, and a depreciation rate of 20%, the depreciation for the first year would be $10,000 \times 20\% = 2,000$.          For the second year, the book value is reduced to $10,000 - 2,000 = 8,000$, so the depreciation would be $8,000 \times 20\% = 1,600$, and so forth.

• Units of Production Method: This method calculates depreciation based on the actual usage or production output of the asset. It is suitable for machinery and vehicles.

• Formula: $\text{Depreciation Expense}=\frac{\text{Cost of Asset}-\text{Residual Value}}{\text{Total Estimated Production}}\times \text{Units Produced in Period}$

• Example: If a machine costs ₹10,000, has a residual value of ₹500, and is expected to produce 100,000 units over its lifetime, with 10,000 units produced in a given year, the depreciation expense for that year would be $\frac{10,000 - 500}{100,000} \times 10,000 = 950 \text{ for that year}$.

4. Factors Affecting Depreciation

• Cost of the Asset: The initial purchase price or cost of acquiring the asset.
• Residual Value: The estimated value of the asset at the end of its useful life.
• Useful Life: The period over which the asset is expected to be used.
• Depreciation Method: The choice of method influences how depreciation is calculated and reported.

5. Accounting Treatment

• Recording Depreciation: Depreciation is recorded as an expense on the income statement, reducing the company’s taxable income. On the balance sheet, it is accumulated in a contra-asset account called "Accumulated Depreciation," which offsets the asset’s book value.
• Impact on Financial Statements: Depreciation impacts both the balance sheet and the income statement. On the balance sheet, accumulated depreciation reduces the asset’s net book value. On the income statement, depreciation expense reduces net income.

6. Depreciation in Indian Accounting Framework

• Accounting Standards: In India, depreciation must be calculated in accordance with Indian Accounting Standards (Ind AS) and the Companies Act, 2013. Ind AS 16, "Property, Plant and Equipment," provides guidelines on depreciation and asset valuation.
• Companies Act, 2013: This Act specifies the methods and rates for calculating depreciation for various types of assets and is applicable to companies in India.

7. Depreciation and Taxation

• Tax Depreciation: Indian tax laws allow for different methods and rates of depreciation compared to financial accounting. Under the Income Tax Act, companies must use the rates specified for tax purposes, which may differ from those used for financial reporting.

8. Conclusion

Depreciation is an essential aspect of accounting that ensures the accurate allocation of an asset’s cost over its useful life. By understanding and applying various depreciation methods, companies can more accurately reflect their financial position and performance while adhering to accounting standards and tax regulations. For commerce students, knowledge of Indian Accounting Standards and tax regulations is crucial for effective financial management and reporting.