Depreciation Accounting

Methods Of Calculating Depreciation Amount

Once the factors affecting depreciation (Cost, Residual Value, Useful Life) are determined, the next step in depreciation accounting is to calculate the amount of depreciation to be charged for an accounting period. Different methods can be used for this allocation, but the goal is always to systematically spread the depreciable cost over the asset's useful life.

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Two of the most common methods are the Straight Line Method and the Written Down Value Method.

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Straight Line Method (SLM)

Under the Straight Line Method, a fixed and equal amount of depreciation is charged each year throughout the estimated useful life of the asset. The assumption is that the asset provides equal service utility each year.

Formulas for SLM:

Annual Depreciation Amount

$Annual\ Depreciation = \frac{Cost\ of\ Asset - Estimated\ Net\ Residual\ Value}{Estimated\ Useful\ Life\ (in\ Years)}$

$Annual\ Depreciation = \frac{Depreciable\ Cost}{Estimated\ Useful\ Life\ (in\ Years)}$

Alternatively, depreciation can be calculated as a percentage of the original cost.

Annual Depreciation Rate (as a percentage of original cost)

$Rate\ of\ Depreciation = \frac{Annual\ Depreciation\ Amount}{Cost\ of\ Asset - Estimated\ Net\ Residual\ Value} \times 100$

$Rate\ of\ Depreciation = \frac{Annual\ Depreciation\ Amount}{Depreciable\ Cost} \times 100$

or, if Residual Value is Zero or negligible:

$Rate\ of\ Depreciation = \frac{1}{Estimated\ Useful\ Life\ (in\ Years)} \times 100$

Answer:

SLM is simple to calculate and understand. It results in a constant charge to the Profit and Loss Account for depreciation each year.

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Written Down Value Method (WDV)

Under the Written Down Value Method (also known as Reducing Balance Method or Diminishing Balance Method), depreciation is calculated at a fixed percentage on the book value (Written Down Value) of the asset at the beginning of each year. Since the book value reduces each year, the amount of depreciation charged also reduces each year.

Formulas for WDV:

Annual Depreciation Amount

$Annual\ Depreciation = Written\ Down\ Value\ at\ the\ beginning\ of\ the\ year \times Rate\ of\ Depreciation$

The rate of depreciation is a fixed percentage. Unlike SLM, the asset's value never reduces to zero under WDV, although it can become negligible.

Calculation of Rate of Depreciation (if not given)

If the cost, residual value, and useful life are known, the rate can be calculated using the formula:

$Rate = 1 - \sqrt[n]{\frac{S}{C}}$

Where:

• R = Rate of Depreciation (as a decimal)
• n = Estimated Useful Life (in years)
• S = Estimated Net Residual Value
• C = Cost of Asset

(Note: This formula calculates the rate. You would then multiply by 100 to get the percentage rate). This formula is less frequently required at introductory levels; typically, the rate is provided.

Answer:

WDV results in a higher depreciation charge in the initial years and a lower charge in later years. This method is preferred for assets that lose more value or are more efficient in their early years. It is also the method predominantly recognised by the Income Tax Act, 1961, in India for computing depreciation for tax purposes.

Straight Line Method And Written Down Method: A Comparative Analysis

The Straight Line Method (SLM) and Written Down Value Method (WDV) are the two main ways to calculate depreciation, and they differ significantly in their approach and impact on financial statements.

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Basis Of Charging Depreciation

• SLM: Depreciation is calculated on the original cost (or depreciable cost) of the asset each year.
• WDV: Depreciation is calculated on the book value (Written Down Value) of the asset at the beginning of the year.

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Annual Charge Of Depreciation

• SLM: The amount of depreciation charged is constant and equal each year throughout the asset's useful life.
• WDV: The amount of depreciation charged is higher in the earlier years and decreases each year over the asset's life.

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Total Charge Against Profit And Loss Account On Account Of Depreciation And Repair Expenses

As assets get older, repair and maintenance expenses tend to increase.

• SLM: Charges a constant depreciation amount each year. As repair expenses increase over time, the total charge to the Profit and Loss Account (Depreciation + Repairs) tends to increase in later years.
• WDV: Charges a decreasing depreciation amount each year. This decreasing charge tends to compensate for the increasing repair expenses in later years, resulting in a more uniform total charge (Depreciation + Repairs) to the Profit and Loss Account throughout the asset's life. This is often considered a merit of the WDV method.

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Recognition By Income Tax Law

• SLM: Recognised by the Companies Act, 2013, for financial reporting, but generally not recognised by the Income Tax Act, 1961, for income tax assessment purposes (except for certain specific assets).
• WDV: Primarily recognised by the Income Tax Act, 1961, for calculating depreciation for tax purposes. Different asset blocks (e.g., buildings, machinery, furniture) have specific WDV rates prescribed by the Income Tax rules.

Therefore, companies often maintain two sets of depreciation calculations: one as per Companies Act/Accounting Standards (which could be SLM or WDV) for financial reporting, and another as per Income Tax Act (mostly WDV) for tax computation.

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Suitability

• SLM: Suitable for assets where the utility value remains relatively constant over time, or where the asset's economic benefit is evenly distributed throughout its life (e.g., buildings, patents, trademarks, furniture - if residual value is zero). It is simple for calculation and presentation.
• WDV: Suitable for assets that lose more value or are more efficient in their earlier years, and require more maintenance as they age (e.g., machinery, vehicles). Its decreasing charge helps balance the increasing repair costs.

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Comparative Table: SLM vs. WDV

Basis	Straight Line Method (SLM)	Written Down Value Method (WDV)
Basis of Calculation	Original Cost (or Depreciable Cost)	Written Down Value (Book Value)
Annual Depreciation Amount	Constant each year	Decreasing each year
Total Charge (Dep. + Repairs) to P&L	Generally increases over time	More uniform over time
Book Value at end of life	Can be reduced to zero or residual value	Never reduced to zero (remains a small value)
Recognition by Income Tax Act	Generally NOT recognised (except few exceptions)	Primarily recognised
Suitability	Assets with uniform utility (buildings, furniture, intangible assets with finite life)	Assets losing more value initially (machinery, vehicles)
Complexity of Calculation	Simple	Slightly more complex (requires annual WDV)

The choice of method affects the reported profit each year and the book value of assets. Accounting standards provide guidance on selecting the appropriate method based on the pattern of consumption of the asset's economic benefits.

Methods Of Recording Depreciation

There are two main ways to record depreciation in the accounting books, which affect how the fixed asset appears in the Balance Sheet.

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Charging Depreciation To Asset Account (Direct Method)

In this method, the amount of depreciation for the period is directly deducted from the cost of the specific asset account in the Ledger.

Journal Entry for Charging Depreciation:

Date	Particulars	LF	Debit (₹)	Credit (₹)
(End of Period)	Depreciation A/c Dr.		[Depreciation Amount]
	To Asset A/c			[Depreciation Amount]
	(Being depreciation charged on asset for the period)

In the Ledger, the Asset Account will be credited with the depreciation amount each year, directly reducing its balance. The balance of the Asset Account in the Ledger and in the Balance Sheet will show the Written Down Value (Book Value) after deducting accumulated depreciation.

Transfer of Depreciation Expense:

At the end of the accounting year, the balance of the Depreciation Account (which is a Nominal Account representing an expense) is transferred to the debit side of the Profit and Loss Account.

Date	Particulars	LF	Debit (₹)	Credit (₹)
(End of Year)	Profit and Loss A/c Dr.		[Total Depreciation for Year]
	To Depreciation A/c			[Total Depreciation for Year]
	(Being depreciation transferred to P&L A/c)

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Creating Provision For Depreciation Account / Accumulated Depreciation Account (Indirect Method)

In this method, the depreciation amount is not credited directly to the Asset Account. Instead, it is credited to a separate account called Provision for Depreciation Account or Accumulated Depreciation Account. The asset continues to appear in the Balance Sheet at its original cost throughout its useful life, while the Provision for Depreciation account shows the total depreciation accumulated up to the reporting date.

Journal Entry for Charging Depreciation:

Date	Particulars	LF	Debit (₹)	Credit (₹)
(End of Period)	Depreciation A/c Dr.		[Depreciation Amount]
	To Provision for Depreciation A/c			[Depreciation Amount]
	(Being depreciation provided on asset)

The Depreciation Account is still transferred to the Profit and Loss Account as an expense at year-end (same entry as above: Dr. P&L A/c, Cr. Depreciation A/c).

The Provision for Depreciation Account is a separate account that accumulates the depreciation charged each year. Its balance increases over time. This account is shown on the liabilities side of the Balance Sheet or is deducted from the Asset's original cost on the assets side.

Presentation in Balance Sheet (Indirect Method):

Balance Sheet as on [Date]

Assets (₹)		Liabilities (₹)
Fixed Assets:		...
Machinery	[Original Cost]
Less: Provision for Depreciation	[Accumulated Depreciation]
	[Net Book Value]
...		...

Advantage of Indirect Method:

It clearly shows the original cost of the asset and the total depreciation charged on it to date in the Balance Sheet, providing more information to the users. This method is preferred, especially when dealing with the disposal of assets.

Disposal Of Asset

When a fixed asset is no longer useful to the business, it is disposed of. Disposal can occur by selling the asset, discarding it as scrap, or exchanging it for a new asset. Accounting for the disposal involves removing the asset from the books and determining any profit or loss on sale.

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The accounting treatment depends on the method used for recording depreciation (Direct vs. Indirect). The Indirect Method (using Provision for Depreciation Account) is more common when discussing asset disposal.

Profit or Loss on Sale of Asset:

The profit or loss on the sale of a fixed asset is calculated by comparing the net sale proceeds with the book value (Written Down Value) of the asset on the date of sale.

Profit on Sale = Sale Proceeds - Book Value (if Sale Proceeds > Book Value)

Loss on Sale = Book Value - Sale Proceeds (if Book Value > Sale Proceeds)

Book Value = Original Cost - Accumulated Depreciation (up to the date of sale)

Profit on sale is a gain and is credited to the Profit and Loss Account. Loss on sale is a loss and is debited to the Profit and Loss Account.

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Use Of Asset Disposal Account

An Asset Disposal Account is often used to facilitate the calculation of profit or loss on the sale of a fixed asset, especially when the Provision for Depreciation method is followed. This account acts as a temporary holding place for all relevant amounts related to the asset being sold.

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Steps using Asset Disposal Account (with Provision for Depreciation):

1. Transfer the Original Cost of the Asset to Disposal Account:

The asset account (e.g., Machinery A/c) which shows the asset at original cost, needs to be credited to remove the disposed asset. The corresponding debit is to the Asset Disposal Account.

Date	Particulars	LF	Debit (₹)	Credit (₹)
(Date of Sale)	Asset Disposal A/c Dr.		[Original Cost of Asset Sold]
	To Asset A/c			[Original Cost of Asset Sold]
	(Being original cost of asset sold transferred to Disposal A/c)

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2. Transfer the Accumulated Depreciation on the Sold Asset to Disposal Account:

The Provision for Depreciation Account shows the total accumulated depreciation for all assets. The accumulated depreciation specifically for the asset being sold needs to be transferred out of this account and into the Asset Disposal Account. Provision for Depreciation A/c has a credit balance, so it is debited to reduce it.

Date	Particulars	LF	Debit (₹)	Credit (₹)
(Date of Sale)	Provision for Depreciation A/c Dr.		[Accumulated Depreciation on Asset Sold]
	To Asset Disposal A/c			[Accumulated Depreciation on Asset Sold]
	(Being accumulated depreciation on asset sold transferred to Disposal A/c)

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3. Record the Sale Proceeds:

Record the cash or bank received from selling the asset. The debit is to Cash/Bank A/c, and the credit is to the Asset Disposal Account.

Date	Particulars	LF	Debit (₹)	Credit (₹)
(Date of Sale)	Cash/Bank A/c Dr.		[Sale Proceeds Received]
	To Asset Disposal A/c			[Sale Proceeds Received]
	(Being cash received from sale of asset)

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4. Transfer the Balance of Asset Disposal Account to Profit and Loss Account:

After steps 1-3, the Asset Disposal Account contains the original cost (debit), accumulated depreciation (credit), and sale proceeds (credit).

Asset Disposal A/c Summary:

Debit (₹)		Credit (₹)
Original Cost		Accumulated Depreciation
		Sale Proceeds
Total Debits		Total Credits

The balance in the Asset Disposal Account represents the Profit or Loss on Sale.

• If Credit side total > Debit side total, the balance is a Debit Balance, representing a Profit on Sale. This profit is transferred to the credit side of the Profit and Loss Account.

  Date	Particulars	LF	Debit (₹)	Credit (₹)
  (Date of Sale)	Asset Disposal A/c Dr.		[Profit Amount]
  	To Profit and Loss A/c			[Profit Amount]
  	(Being profit on sale of asset transferred to P&L A/c)

• If Debit side total > Credit side total, the balance is a Credit Balance, representing a Loss on Sale. This loss is transferred to the debit side of the Profit and Loss Account.

  Date	Particulars	LF	Debit (₹)	Credit (₹)
  (Date of Sale)	Profit and Loss A/c Dr.		[Loss Amount]
  	To Asset Disposal A/c			[Loss Amount]
  	(Being loss on sale of asset transferred to P&L A/c)

Using the Asset Disposal Account simplifies the process, especially when multiple assets are sold or complex calculations are involved, by isolating the transaction's components in one place before determining the final profit or loss.

Effect Of Any Addition Or Extension To The Existing Asset

Additions or extensions to an existing fixed asset are usually considered Capital Expenditure if they result in an increase in the asset's earning capacity, reduce operating costs, or extend its useful life. Routine repairs and maintenance are generally considered Revenue Expenditure and are charged to the Profit and Loss Account.

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When a significant addition or extension is made to an existing asset, the cost of the addition is added to the original cost of the asset in the books. This increases the book value of the asset and affects the calculation of future depreciation.

Accounting Treatment:

• The cost of the addition/extension is debited to the Asset Account (or added to its original cost if a separate account is not maintained for additions).
• The corresponding credit is to Cash/Bank or Creditor (if purchased on credit).

Date	Particulars	LF	Debit (₹)	Credit (₹)
(Date of Addition)	Asset A/c (or Asset name) Dr.		[Cost of Addition]
	To Cash/Bank A/c (or Creditor A/c)			[Cost of Addition]
	(Being addition/extension made to asset)

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Impact on Depreciation:

After an addition or extension, the depreciation for the current period and future periods needs to be recalculated.

• If SLM is used: The total depreciable cost increases (Original Cost + Cost of Addition - Residual Value). This new depreciable cost is then spread over the remaining useful life of the *original* asset plus the addition. Alternatively, the addition may be depreciated separately over its own useful life or the remaining life of the original asset, whichever is shorter. A common approach is to calculate depreciation on the increased book value from the date of addition for the remaining life.
• If WDV is used: The cost of the addition is added to the Written Down Value of the asset at the beginning of the period (or on the date of addition). Depreciation for the period is then calculated on this increased WDV at the applicable WDV rate. Depreciation will be charged for the full period (or pro-rata from the date of addition).

Answer:

Proper accounting for additions and extensions is necessary to ensure that the book value of the asset is correctly stated and that the appropriate amount of depreciation is charged in the current and future periods.