Depreciation Accounting: Concept, Causes & Factors

1. What is Depreciation?

When a business purchases a fixed asset—such as a delivery truck, a manufacturing machine, or office computers—the asset is expected to serve the business over several years.

However, with continuous usage, the passage of time, physical wear and tear, and technological advancement, the asset gradually and permanently loses its value and working capacity.

Depreciation is the permanent and gradual decrease in the book value of a tangible fixed asset due to wear and tear, passage of time, or obsolescence.

Standard Definitions:

1. Institute of Chartered Accountants of India (ICAI - AS 6 / Ind AS 16):

   “Depreciation is a measure of the wearing out, consumption or other loss of value of a depreciable asset arising from use, effluxion of time or obsolescence through technology and market changes.”

2. According to R.N. Carter:

   “Depreciation is the gradual and permanent decrease in the value of an asset from any cause.”

2. Essential Distinctions: Depreciation, Depletion, Amortization & Fluctuation

In university exams, distinguishing between these related accounting terms is a classic, high-scoring question:

Crucial Note: Land is NEVER depreciated! Land has an indefinite economic life and does not wear out with use. In fact, land usually appreciates in value over time!

3. Causes of Depreciation

Why do fixed assets lose value? The causes fall into internal and external factors:

                          Causes of Depreciation
                                    |
         +--------------------------+--------------------------+
         |                                                     |
    Internal Causes                                       External Causes
- Wear and tear from physical use                     - Technological Obsolescence
- Natural decay, rust, weather damage                 - Effluxion / Passage of time
- Depletion / Exhaustion of reserves                  - Accidents, fire, or flood

1. Internal Causes:

• Physical Wear and Tear: Moving parts of machines, engine friction, vibration, and road friction gradually wear out physical equipment.
• Exposure to Weather & Decay: Rain, rust, dampness, and exposure to heat cause physical deterioration of vehicles, factory roofs, and outdoor structures even if unused.

2. External Causes:

• Technological Obsolescence: A modern, faster machine or software system is invented, making existing functional equipment economically obsolete!
  • Example: Black-and-white television assembly plants or 3G mobile telecom towers becoming obsolete when 4G/5G technology emerged.
• Effluxion (Passage) of Time: Certain assets have a fixed legal duration (e.g., a 10-year leasehold property or software license). Even if the business remains completely shut for a year, one year’s legal value expires permanently.
• Abnormal Accidents & Disasters: Damage caused by factory fires, vehicle collisions, or earthquake damage.

4. Objectives of Providing Depreciation

Why must a business record depreciation in its books?

1. Ascertainment of True Net Profit or Loss: Depreciation is an operational business expense. If depreciation is ignored, operating expenses are understated, and the Profit & Loss Account will show falsely inflated profits!
2. True and Fair View of Financial Position: Fixed assets must be shown on the Balance Sheet at their net unexpired book value (Cost - Accumulated Depreciation). Ignoring depreciation shows artificially inflated assets, misleading investors and banks.
3. Provision of Funds for Asset Replacement: By debiting depreciation to the P&L Account each year, an equivalent amount of business cash is retained inside the business instead of being distributed away as dividends to owners. When the machine reaches the end of its life, accumulated funds are available to buy a new one!
4. Income Tax Compliance: Depreciation is an allowable tax deduction under Section 32 of the Indian Income Tax Act 1961, reducing taxable business income and tax liability.
5. Prevention of Capital Erosion: If dividends are paid out of artificially inflated profits (without deducting depreciation), the company is essentially paying dividends out of its own invested capital!

5. Key Factors Determining the Amount of Depreciation

To calculate how much depreciation to charge each year, the accountant must evaluate three key variables:

+-----------------------------------------------------------+
| 1. Historical Cost of the Asset                           |
| Purchase Price + Freight + Customs Duty + Installation +  |
| Trial Run Costs before commercial operation starts.       |
+-----------------------------+-----------------------------+
                              |
                              v
+-----------------------------------------------------------+
| 2. Estimated Scrap Value (Residual / Salvage Value)       |
| The net monetary amount expected to be recovered from     |
| selling the machine as metal scrap at the end of its life.|
+-----------------------------+-----------------------------+
                              |
                              v
+-----------------------------------------------------------+
| 3. Estimated Economic Useful Life                         |
| The expected number of working years (or operating hours) |
| the machine will efficiently function in operations.      |
+-----------------------------------------------------------+

Total Depreciable Cost Formula:

Total Depreciable Cost = Historical Cost - Estimated Scrap Value

6. Syllabus Activity 2 Introduction: Calculating Annual Depreciation Rate

In the DAVV BBA practical syllabus activity, students are asked to calculate the basic depreciation rate based on estimated life:

Annual Depreciation Percentage Rate = 100 / Estimated Useful Life in Years

Everyday Example:

• Household Asset: A family laptop purchased for ₹60,000.
• Estimated Useful Life: 5 years.
• Annual Depreciation Percentage: 100 / 5 = 20% per year

7. Summary & Quick Revision Checklist

• Depreciation is the permanent, gradual decrease in the book value of tangible fixed assets.
• Depletion applies to natural wasting resources (mines, oil); Amortization applies to intangible assets (patents, goodwill).
• Land does not depreciate because its useful life is indefinite.
• Depreciation is recorded to calculate true profit, true asset values, fund future replacements, and save income tax.
• Three key factors: Total Acquisition Cost, Estimated Scrap/Residual Value, and Estimated Useful Life.