Lesson 22 of 33 · Free
Contents
- 1 Depreciation
- 1.1 Why depreciate at all?
- 1.2 Three things you need to compute depreciation
- 1.3 Method 1 — Straight-line
- 1.4 Method 2 — Written-Down Value (Declining Balance)
- 1.5 Method 3 — Units of Production
- 1.6 The journal entry
- 1.7 Depreciation vs. Amortisation vs. Depletion
- 1.8 What happens when an asset is sold
- 1.9 Lesson recap
- 1.10 Practical Indian Application
- 1.11 Worked Example — Surya Pharma Depreciation
- 1.12 Common Depreciation Mistakes
- 1.13 Frequently Asked Questions
- 1.14 Component Accounting and Impairment
Depreciation
Spreading a long-term asset’s cost across its useful life. Straight-line, WDV, units-of-production — and why India runs two methods in parallel.
Why depreciate at all?
You spend ₹10 lakh on a machine that will produce goods for 10 years. The matching principle says: don’t expense the whole ₹10 lakh in year one — match the cost to the years that benefit from it. Spread ₹1 lakh of expense across each of the 10 years. That’s depreciation.
Depreciation is a non-cash expense. The cash already left when you bought the asset. The annual expense is just an allocation of that earlier outflow.
Three things you need to compute depreciation
- Cost — the asset’s full acquisition cost, including freight, installation, and any directly attributable expense.
- Useful life — how many years (or units of production) the asset is expected to be useful. Typical: 3-5 years for IT equipment, 10 years for furniture, 20-25 for buildings.
- Salvage / residual value — estimated value at the end of useful life. Often zero for IT, 5-10% for vehicles and machinery.
The amount to depreciate is Cost − Salvage.
Method 1 — Straight-line
Example: ₹10 lakh machine, ₹1 lakh salvage, 5-year life → (10 − 1) ÷ 5 = ₹1.8 lakh per year.
Simplest method. Used by most companies for book purposes. Required under Schedule II of the Indian Companies Act unless management justifies otherwise.
Method 2 — Written-Down Value (Declining Balance)
A fixed percentage of the asset’s remaining book value is depreciated each year. Front-loads expense — more in early years, less later.
Example: ₹10 lakh machine, 40% rate. Year 1: ₹4 lakh. Year 2: ₹2.4 lakh (40% of ₹6 lakh remaining). Year 3: ₹1.44 lakh. And so on.
Required by the Indian Income-Tax Act for tax computations. Most plant and equipment depreciate at 15% WDV for income-tax; computers at 40%.
Method 3 — Units of Production
Depreciation tied to actual usage. Common for machinery where wear correlates with output.
Each period’s expense = Per-unit rate × Units produced. If output drops, so does depreciation. Used in mining, certain process industries.
The journal entry
Mar 31 Depreciation Expense Dr. 1,80,000
To Accumulated Depreciation 1,80,000
(Being depreciation for the year on machinery)
Accumulated depreciation is a contra-asset — it sits next to the gross asset on the balance sheet but with a credit balance. Year after year, accumulated depreciation grows. The asset’s “net book value” = Gross cost − Accumulated depreciation.
Depreciation vs. Amortisation vs. Depletion
- Depreciation — for tangible fixed assets (machinery, buildings, vehicles).
- Amortisation — same idea but for intangible assets (patents, trademarks, software, goodwill in some frameworks).
- Depletion — for natural-resource assets (mines, oil reserves) based on extraction.
The mechanics are identical; only the terminology differs.
What happens when an asset is sold
Three numbers matter: cost, accumulated depreciation, and sale proceeds. Sale proceeds vs. net book value determines gain or loss.
Example: machine cost ₹10 lakh, accumulated depreciation ₹7.2 lakh (so NBV = ₹2.8 lakh), sold for ₹3.5 lakh.
Dr. Cash 3,50,000
Dr. Accumulated Depreciation 7,20,000
Cr. Machinery 10,00,000
Cr. Gain on Sale of Asset 70,000
Lesson recap
- Depreciation matches asset cost to the years that benefit.
- Three inputs: cost, useful life, salvage.
- Three methods: straight-line, WDV, units of production.
- India uses straight-line for books, WDV for tax — that’s why deferred tax exists.
- Depreciation is non-cash; the cash left when you bought the asset.
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Practical Indian Application
Reference framework: Schedule II of Companies Act 2013 for useful lives; Section 32 of Income-tax Act with prescribed WDV rates; AS 10 / Ind AS 16 for property, plant and equipment; Ind AS 36 / AS 28 for impairment testing.
Worked Example — Surya Pharma Depreciation
Suppose Surya Pharma, Vadodara, buys plant for ₹50,00,000 on 1 April 2025 with useful life 10 years and residual value ₹5,00,000. SLM annual depreciation = (50−5)/10 = ₹4,50,000. WDV at 25% would be 25% × ₹50,00,000 = ₹12,50,000 in year 1. For Income-tax purposes under Section 32, the rate for general plant is 15% on WDV: ₹50,00,000 × 15% = ₹7,50,000. The Companies Act books show ₹4,50,000 expense (SLM), the tax computation deducts ₹7,50,000 (WDV) — the timing difference creates a deferred tax liability that reverses over the asset’s life.
Common Depreciation Mistakes
- Using the same rates for Companies Act and Income-tax — the two regimes intentionally diverge
- Forgetting the half-rate convention for assets used < 180 days in the year
- Depreciating land (it has indefinite life and should never be depreciated)
- Missing component accounting under Ind AS 16 for major asset parts
Frequently Asked Questions
Why are useful lives in Schedule II different from Income-tax depreciation rates?
Schedule II prescribes useful lives for true-and-fair accounting; the Income-tax Act prescribes accelerated rates as a fiscal incentive for investment. The two diverge by design.
When can a useful life shorter than Schedule II be used?
When justified by management (e.g., harsher operating conditions, higher technological obsolescence). Disclosure with rationale is required.
How is depreciation calculated on assets purchased mid-year?
Pro-rated for the number of days the asset was put to use. For Section 32 of the Income-tax Act, assets used for less than 180 days in the year get half-rate depreciation.
Component Accounting and Impairment
Ind AS 16 mandates component accounting — major parts of an asset with materially different useful lives must be depreciated separately. An aircraft engine (depreciated over 8 years) is separated from the aircraft body (depreciated over 25 years); a power plant boiler from the turbine; a factory’s HVAC system from the building structure. AS 10 also recommends but does not strictly mandate this. Indian airlines (IndiGo, Air India) and power generators (NTPC, Tata Power) apply component accounting extensively. Impairment testing under Ind AS 36 / AS 28 requires annual review of indicators: market decline, technological obsolescence, regulatory change, physical damage. If indicators exist, the recoverable amount is compared with carrying value; the shortfall is impairment loss charged to P&L.
Workflow Best Practices
Maintain a fixed-asset register with serial numbers, location, depreciation method, useful life, and salvage value for every asset. Reconcile monthly with the gross block and accumulated depreciation in books. Periodic physical verification (annually for major assets, every 3-5 years for minor) ensures the register stays accurate. This discipline is required under the Companies Act and supports both audit and insurance claims.
Depreciation Acceleration Strategies
Beyond standard Section 32 rates, several depreciation accelerators exist under Indian tax law:
- Additional Depreciation (Section 32(1)(iia)): Extra 20% (10% if used < 180 days) on new plant & machinery in manufacturing. Powerful incentive for new capex.
- 100% Depreciation: On energy-saving devices, pollution control equipment, certain renewable energy assets
- Sunset clauses: Many accelerated rates have expiry dates — verify current applicability before claiming
- Section 35AD: 100% deduction of capital expenditure on specified businesses (hotels, hospitals, cold chain) in year of incurrence
These provisions reflect government policy direction — investment in manufacturing, exports, infrastructure gets tax preferences. Tax planners use these strategically when advising on capex timing and structuring.