Depreciation Definition, Example and Importance
Depreciation Definition – A charge on the income statement representing a portion of the cost of a tangible asset such as a building or a machine. The cost of such assets is charged over their estimated useful life.
With the passage of time, the monetary value of an asset decreases due to usage, wear and tear or obsolescence. This decrease in the value of asset is term as Depreciation . Assets such as machinery, equipment, facilities, etc are the examples of assets that get depreciate over the time. However, there are some assets whose value increases with the period of time such as land.
Most of the enterprise depreciate the assets for tax purpose as well as accounting purpose. However, the right practice is to depreciate the assets according to rules. The accounting of depreciation is quite hectic for accounting students as it is a non cash transaction. Its effect reflects in the books of account only. There is no actual transfer of cash. It also shows the decline in the market value of the asset.
Methods To Calculate Depreciation
There are various methods of calculating depreciation. However, in this article we will discuss the most popular methods of depreciation – Straight line and Written down value method.
Straight line method – It is one of the method for computing depreciation. In this method the difference in assets cost and salvage value is divided by the asset’s estimated life. This is the simplest method as a constant amount of depreciation is taken throughout the assets’s life.
Depreciation = (Cost of Asset – Salvage Value)/ life of the asset
For example – A machinery costs is Rs 5,00,000. The asset’s life is 5 years. Salvage value is 50,000.
Depreciation = (5,00,000 – 50,000)/5
= Rs. 90,000
The same amount of depreciation will be charged for the next 4 years as well.
Written Down Value Method (WDV) – This method is also known as the diminishing balance method. In this method the value of asset decreases every year with the passage of time to the extent of certain percentage. From accounting point of view, this method is considered best.
For example – A facilities costs Rs. 3,00,00 which has the estimated life of 8 year. The depreciation to be charge @10%
Now the depreciation for 1st year will be (3,00,000×1o)/100 = 30,000
Depreciation for 2nd year will be applied on amount (2,70,000 ×1o) /100 that is (3,00,00 – 30,000) = 27,000. The process will go on for 8 years till the asset value does not becomes zero.
In order to understand depreciation definition more clearly, let’s discuss an example. The cost of building is 1,00,000. The life is 10 year. Charge depreciation @5%. Find out the depreciation using straight method.
Depreciation = (1,00,000×5)/100
As per straight line, constant depreciation of 50,000 will be charged.
Related Financial Terms of Depreciation
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- Zero – Based Budgeting
Importance of Depreciation
Without the importance of depreciation, depreciation definition is incomplete.
- It shows the true value of the asset.
- A tool for the purpose of tax deduction
- It results in increase in the tax savings.
- Depreciation appears on Income statement so it also helpful in estimating the true net profit.