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What is Depreciation?
Depreciation is the systematic reduction in the value of a fixed asset over its useful life. It reflects the wear and tear, obsolescence, or consumption of an asset as it contributes to generating income for the business. Under the matching principle, depreciation expense is recognized in the profit and loss statement to align costs with the revenue generated by the asset.
For bankers and financial professionals, understanding depreciation is essential because it impacts:
- Balance sheet asset valuations
- Profit and loss calculations
- Cash flow analysis (non-cash expense)
- Tax deductions and compliance
Key Characteristics of Depreciable Assets
Not all assets depreciate. Depreciable assets must meet specific criteria:
- Tangible fixed assets: Physical items like buildings, machinery, vehicles, furniture
- Finite useful life: The asset must have a limited lifespan (not indefinite)
- Used in business operations: Must contribute to income generation
- Subject to wear and tear: Value reduces due to use, time, or obsolescence
Non-depreciable assets include land, investments, goodwill (if not written down), and current assets like inventory and receivables.
Factors Affecting Depreciation
Three core factors determine how much depreciation is charged each period:
| Factor | Definition | Example |
|---|---|---|
| Cost of Asset | Original purchase price including acquisition costs | Machine purchased for ₹10,00,000 |
| Useful Life | Period over which the asset will be used productively | 5 years for machinery |
| Residual/Salvage Value | Estimated value at end of useful life | ₹1,00,000 after 5 years |
Methods of Depreciation
The Accounting Standards (AS-6 or Ind-AS 16) permit multiple depreciation methods. Choose the one that reflects how the asset is consumed:
1. Straight-Line Method (SLM)
Charges equal depreciation each year. Most common and suitable for assets with uniform benefit delivery.
Formula: Annual Depreciation = (Cost – Salvage Value) / Useful Life
Example: Machine cost ₹10,00,000, salvage value ₹1,00,000, useful life 5 years. Annual depreciation = (10,00,000 – 1,00,000) / 5 = ₹1,80,000
2. Diminishing Balance Method (DBM)
Charges depreciation as a percentage of the book value (net value) each year. Depreciation decreases annually, suitable for assets that lose value faster initially.
Formula: Annual Depreciation = Book Value × Depreciation Rate
Example: Cost ₹10,00,000, rate 20% per annum. Year 1: 10,00,000 × 20% = ₹2,00,000. Year 2: (10,00,000 – 2,00,000) × 20% = ₹1,60,000
3. Units of Production Method
Depreciation based on units produced or hours worked. Suitable for machinery with variable usage patterns.
Formula: Annual Depreciation = (Cost – Salvage Value) × (Units produced this year / Total estimated units)
4. Annuity Method
Less common; combines depreciation with interest on capital. Primarily used for long-term assets in specialized scenarios.
Accounting Treatment: Journal Entries
Depreciation is recorded through a two-step process:
Method 1: Direct Method (Older Practice)
Depreciation is credited directly to the asset account:
Journal Entry: Depreciation Expense (Dr.) / Fixed Asset (Cr.)
Method 2: Accumulated Depreciation Method (Standard Practice)
A contra-asset account is used to track cumulative depreciation:
Journal Entry: Depreciation Expense (Dr.) / Accumulated Depreciation (Cr.)
This method is preferred because it preserves the original cost of the asset and clearly shows how much depreciation has been charged historically.
Presentation on Balance Sheet
Fixed assets are presented as:
Fixed Asset (Gross)
Less: Accumulated Depreciation
= Net Book Value
Example: Machinery purchased for ₹10,00,000 with accumulated depreciation of ₹3,00,000 is shown as ₹7,00,000 on the balance sheet.
Impact on Financial Statements
Profit & Loss Statement: Depreciation is an expense that reduces net profit, even though no cash outflows occur.
Cash Flow Statement: Depreciation is added back to net profit in the operating activities section (indirect method) because it's a non-cash expense.
Balance Sheet: Reduces the carrying value of fixed assets and affects retained earnings through reduced profits.
Tax Perspective for Banks
The Income Tax Act allows different depreciation rates for banking assets. Banks must align book depreciation with tax regulations for compliance. Common rates include:
- Buildings: 5% to 10% depending on construction material
- Plant and machinery: 15% to 20%
- Vehicles: 20%
- Computers and IT equipment: 40%
Exam-Critical Scenarios
Asset Purchased Mid-Year: Depreciation is calculated proportionally for the period the asset is owned.
Asset Sold During the Year: Depreciation is charged up to the date of sale. Gain or loss on sale is calculated as: Selling Price – Book Value at Date of Sale.
Change in Useful Life: Revised depreciation is calculated on the remaining book value over the revised remaining useful life (prospective adjustment).
Key exam points
- Depreciation is a non-cash expense that systematically reduces fixed asset value over its useful life
- Only tangible assets with finite lives and used in business operations are depreciable; land and investments are not
- Straight-Line Method (equal annual charge) and Diminishing Balance Method (decreasing charge) are primary methods
- Journal entry standard practice: Depreciation Expense (Dr.) / Accumulated Depreciation (Cr.)
- Accumulated Depreciation is a contra-asset account shown on the balance sheet to preserve original cost transparency
- Depreciation is non-cash; it's added back in cash flow statements but reduces profit in P&L
- For assets purchased mid-year or sold, depreciation is calculated proportionally for the period of ownership
- Tax rules may differ from accounting standards; banks must comply with Income Tax Act depreciation rates
- Net Book Value = Cost – Accumulated Depreciation; this is the value shown on balance sheets
- Changes in useful life are treated prospectively on remaining book value, not retroactively
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