What is Depreciation? (AS-6)

Depreciation is the gradual, permanent, and continuous fall or decrease in the value of a fixed asset. It’s a non-cash business expense that is “charged” against the profit of a company over the asset’s useful life.

According to Accounting Standard (AS) 6, depreciation is:

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

Simply put, you buy a machine for ₹1,00,000, and you plan to use it for 10 years. You can’t call the entire ₹1,00,000 an expense in Year 1. Instead, you spread that cost over the 10 years you use it. This process of spreading the cost is called depreciation.

What is a “Depreciable Asset”?

As per AS-6, an asset is depreciable only if it meets three conditions:

1. It is expected to be used for more than one accounting period.

2. It has a limited useful life. (This is why land is generally not depreciated).

3. It is held by the business for use in production, supply of services, or for administrative purposes (i.e., it is not held for the purpose of resale).

Why is Depreciation Necessary? (Significance)

1. To Ascertain Correct Profit: Depreciation is a cost of earning revenue. To find the true profit for a period, you must deduct all costs (including depreciation) from the revenues of that period.

2. To Show a True Financial Position: If you don’t charge depreciation, your assets will be shown at their original cost in the Balance Sheet, which is misleading. Depreciation ensures assets are shown at their “true and fair” value.

3. To Fund Asset Replacement: It creates a fund by setting aside a portion of profits each year, so you have money available to buy a new asset when the old one wears out.

4. To Account for Wear and Tear: Assets (like machinery) lose value simply from being used.

5. To Account for Obsolescence: An asset may become outdated due to new technology (e.g., an old typewriter is replaced by a computer) long before it physically breaks down.

recording” depreciation” (the” two” ways)

There are two main ways to record depreciation in the books:

1. When Provision for Depreciation Account is NOT Maintained:

   • Depreciation is debited, and the Asset Account is credited.

   • Journal Entry: Depreciation A/c Dr. / To Asset A/c

   • In this method, the Asset Account in the Balance Sheet is always shown at its Written Down Value (Cost – Depreciation).

2. When Provision for Depreciation Account IS Maintained:

   • Depreciation is debited, and a new account called “Provision for Depreciation” (or “Accumulated Depreciation”) is credited.

   • Journal Entry: Depreciation A/c Dr. / To Provision for Depreciation A/c

   • In this method, the Asset Account in the Balance Sheet is always shown at its Original Cost. The “Provision” is shown as a deduction from it.

Methods of Providing Depreciation

While there are many methods, the two most common methods required for BBA/MBA students are the Straight Line Method (SLM) and the Written Down Value (WDV) Method.

1. Straight Line Method (SLM)

This method is also known as the “Fixed Installment Method.”

• What it is: A method where the depreciation is calculated on the Original Cost of the asset.

• Key Feature: The amount of depreciation remains constant (fixed) every single year throughout the asset’s life.

• Formula:

  $$Depreciation = \frac{(Original\;Cost – Estimated\;Scrap\;Value)}{Estimated\;Useful\;Life\;(in\;Years)}$$

✅ Merits of SLM

• It is very simple and easy to calculate.

• The asset’s value can be completely written off to zero (or its scrap value) at the end of its life.

❌ Demerits of SLM

• It is unrealistic. The burden on the Profit & Loss account increases over the years (as repair costs go up, but the depreciation charge stays the same).

• It is not recognized by income tax authorities in India for most assets.

Example: Straight Line Method (SLM)

Illustration: Mr. Ramesh purchased a second-hand machine for ₹24,000 on 1st April 2006. He spent ₹10,000 on its overhaul and installation. Depreciation is written off at 10% p.a. on the original cost. On 30th June 2008, the machine was sold for ₹19,000. Prepare the Machine Account (assuming accounts close on 31st Dec).

Solution:

Working Note:

1. Original Cost of Machine = Purchase Price + Installation = ₹24,000 + ₹10,000 = ₹34,000

2. Annual Depreciation (10% of Cost) = 10% of ₹34,000 = ₹3,400 per year

Machinery Account

2. Written Down Value (WDV) Method

This method is also known as the “Diminishing Balance Method” or “Reducing Balance Method.”

• What it is: A method where depreciation is calculated on the Written Down Value (Book Value) of the asset, which is the (Original Cost – All Previous Depreciation).

• Key Feature: The rate of depreciation is constant (e.g., 10%), but the amount of depreciation decreases every year.

• Result: The value of the asset can never become zero under this method.

✅ Merits of WDV

• It is more logical. The depreciation is high in the early years (when the asset is most efficient) and low in the later years (when repair costs are high).

• It is recognized by income tax rules in India.

❌ Demerits of WDV

• The asset can never be fully written off to zero.

• Calculating the rate (if not given) is complex.

Example: Written Down Value (WDV) Method

Illustration: Lakshmi Narain Co. Ltd. purchased machinery on 1st April 2006 for ₹45,000. It purchased another machine on 1st Oct 2006 for ₹30,000. Depreciation is charged at 10% p.a. on the WDV method. Accounts close on 31st Dec. Show the Machinery Account for 2006 and 2007.

Solution:

Machinery Account

Dr. Cr.

Working Notes (W.N.)

You can provide the values or ask me to compute all depreciation workings (W.N. 1, W.N. 2, etc.), and I will complete this section cleanly.

If you want this in image form, PDF, or T-account style, I can generate that too.

1. Depreciation for 2006:

   • On M1: ₹45,000 x 10% x (9/12) = ₹3,375

   • On M2: ₹30,000 x 10% x (3/12) = ₹750

   • Total = ₹4,125

2. Depreciation for 2007 (Calculated on WDV):

   • WDV of M1 = (₹45,000 – ₹3,375) = ₹41,625

   • WDV of M2 = (₹30,000 – ₹750) = ₹29,250

   • Total WDV = ₹41,625 + ₹29,250 = ₹70,875

   • Total Depreciation for 2007 = 10% of ₹70,875 = ₹7,087.50

SLM vs. WDV: Key Differences

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