Depreciation is reduction/fall in the value of assets over a period of time.
In accounting terms, when a fixed asset is purchased, it is recorded in books of account at its acquisition/purchase cost.
However, fixed assets are used to earn revenues for a number of accounting periods in future with the same acquisition cost until the concerned fixed asset is sold or discarded.
It is therefore necessary that a part of the acquisition cost of the fixed asset is treated/allocated as an expense in each of the accounting period in which it is utilised.
The amount or value of fixed assets allocated in such manner to respective accounting period is called Depreciation.
Value of assets decrease over time due to the following reasons:
- Obsolescence through technology and market changes
- Wear & tear due to its use in business
- Efflux of time when it is not being used
- Decrease in market value
- Depletion in case of mines & other natural resources
Example 1: You purchase a car for 10 Lakh and drive it every day for a year. At the end of 1 year, can you sell it for the same 10Lakh? No. Depreciation is due to usage of the car, in this case.
Example 2: You purchase a car for 10Lakh and just park it without driving for a year. At the end of 1 year, can you sell it for the same 10Lakh? No. In this case, depreciation is due to Efflux of time.
Example 3: You purchase a Smart Phone for Rs 30,000 and don't use it. At the end of 2 years, can you sell it for the same Rs 30,000? No. In this case, depreciation is due to technological changes.
Straight-Line Depreciation Method
Straight-line depreciation is one of the most simple and widely used methods. In this, an equal amount is written off every year during the working life of an asset so as to reduce the cost of the asset to nil or its residual value at the end of its useful life.
The advantage of this method is that it is simple to apply and gives accurate results, especially in the case of leases, and also in case of plant and machinery. This method is also known as Fixed Instalment Method.
Straight Line Depreciation = (Cost of Asset – Scrap Value)/Useful life.
Straight Line Depreciation Rate = (Straight Line Depreciation/Cost of Asset) x 100
The underlying assumption of this method is that the particular tangible asset generates equal utility during its lifetime. But this cannot be true under all circumstances. The expenditure incurred on repairs and maintenance will be low in earlier years, whereas the same will be high as the asset becomes old.
Apart from this, the asset may also have varying capacities over the years, indicating logic for unequal depreciation provision.
However, many assets have insignificant repairs and maintenance expenditures for which the straight-line method can be applied.
Depreciation using Written down Value (WDV) Method Visit Here