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Fixed assets like buildings, vehicles, rental properties, commercial properties, and production
equipment all decline over time. Depreciation is an accounting method used to calculate the
decrease in value of a fixed asset while it’s used in a company’s revenue-generating operations.

After an asset is purchased, a company determines its useful life and salvage value (if any).
Then, the asset cost is depreciated over time based on its useful life.

Understanding depreciation is important for getting the most out of your assets at tax time. You
can claim depreciation to reduce your total taxable income, saving you money on your taxes.

Measuring depreciation is important as it allocates the cost of an asset over the periods that the
company benefited from its use (matching revenues and expenses). We’ll explore different ways
to calculate steady and accelerated depreciation so you can measure depreciation on different
types of assets. We’ll also take a look at how depreciation relates to taxation and accounting,
what assets you can claim for depreciation, and common causes of asset depreciation.

What Is Depreciation?

Depreciation is the decline in the book value of a fixed asset over time. When you have a fixed
asset like a vehicle, building, or piece of equipment, these things will naturally suffer some wear
and tear over time. Depreciation measures the economic effect of this wear and tear and allows
you to allocate that change in value over the asset’s usable life.

Depreciation continues over the useful life of the asset. In some cases, an asset may decline in
value at a steady rate, while others may decline more rapidly in years where they see heavier
use.

Depreciation and Taxation

Understanding depreciation is important for calculating its impact on your taxes. When the value
of a fixed asset declines, you can claim that depreciation as a tax deduction for your business.
This helps reduce your total taxable income.

There are several rules for the tax purposes when claiming depreciation as a deduction: 1

 The asset must be property that you own

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 The asset must be used for your business to produce income

 You need to be able to determine the useful life of the asset

 The asset’s useful life must be longer than 1 year

You can start calculating depreciation when the fixed asset is placed in service, meaning it is
ready for use in your business, even if you haven’t started using it yet. For example, if you buy a
machine for your company, you can begin calculating depreciation when it arrives on site the
same year, even if you don’t use it until the next year.

Depreciation ends when the asset reaches the end of its usable life or when you sell it.

Depreciation Practices in Accounting

In accounting, depreciation is recorded as an expense that gradually reduces the book value of
an asset. Since an asset benefits your business over an extended period, this expense is recorded
over time to allocate the asset’s cost over the periods it benefited the company.

Depreciation isn’t an asset or a liability itself—it’s a method used to measure the change in the
carrying value of a fixed asset. It’s recorded as a contra-asset under the assets section of your
balance sheet. You’ll usually record annual depreciation so you can measure how much to claim
in a given year, as well as accumulated depreciation so you can measure the total change in
value of the asset to date.

Causes of Depreciation:

1. By Constant Use: The constant use of any asset by a business causes wear and
tear, which causes a decrease in the value of those assets. As a result, the capacity of
the asset to serve in the business is reduced.
2. By Passing of Time: The value of assets also decreases when an asset is exposed
to forces of nature like wind, rain, etc., even if it is not put to any use.
3. By Obsolescence: Obsolescence is also one main reason for depreciation. An
existing asset can become outdated in some time due to technological changes,
improvements in production methods, changes in market demand, etc., as a result,

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the demand for the-asset decreases, as the old asset is not able to fulfil the
requirements of the business.
4. By Expiration of Legal Rights: There are some assets that are used in the business
for a certain time period. The time period is determined by an agreement in which
the tenure to use that particular asset is mentioned. Example: Patents, Copyrights,
Lease, etc.
5. By Accident: Assets can be destroyed due to some abnormal factors, such as
earthquakes, floods, etc. This leads to a decrease in the value of the asset. Thus, it
needs to be taken into account.

Factors Affecting Depreciation:

1. Cost of the Asset: The cost of a fixed asset is determined by adding all the expenses
incurred on bringing the asset to usable condition with the purchasing price of that asset. If
the cost of the asset is more, the depreciation charged on that asset will also be higher. For
example, the company purchased an asset for ₹50,000 and also spend ₹10,000 on its
installation. In this case, the cost price to be shown in the books will be 50,000 +10,000 =
₹60,000, and depreciation will be calculated at ₹60,000.
2. Estimated Useful Life: The number of years for which an asset can be effectively used in
the business is called its estimated useful life. A machine having more number of useful
years will have less yearly depreciation as compared to a machine that has a lesser number
of useful years.
3. Estimated Scrap Value: Scrap value is the net realisable value of an asset at the end of its
effective life. It is also known as residual value or break-up value. It is deducted from the
total cost of the asset at the time of calculating depreciation.
For example, in 2020, a company purchased a machine for ₹1,00,000. At the time of
purchase, the scrap value of the machine was estimated at ₹10,000 at the end of 3 years of
use. So depreciation is calculated as:

1,00,000- 10,000 = 90,000

90,000/3= 30,000

Therefore the annual depreciation on that machinery will be ₹30,000.

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Need for Depreciation:

1. For Ascertaining the True Profit or Loss: The actual profit of any business can only be
determined when all the expenses and losses of the business for the particular year are
deducted from the total revenue earned by the business. If the company does not provide
depreciation on assets, then it will not be adjusted in the revenue of the firm, and also the
assets will be recorded as over-valued. Because of this, the true financial position of the
company is not ascertained
2. For Tax Benefit: Depreciation provides tax benefits to the company as the depreciation is
adjusted to the profit before the payment of taxes. By this, the taxable income is reduced,
and the firm has to pay less tax on a decreased profit.
3. To Ascertain the Accurate Cost of Production: Depreciation is similar to any other
expenses that are incurred in the normal course of business. The accurate cost of production
can only be determined after taking depreciation into account.
4. To Provide Fund for Replacement of an Asset: Depreciation is debited to Profit and Loss
A/c, but it is a non-cash expense, i.e., no actual cash is paid in charging depreciation.
Hence, the amount of the depreciation is retained in the business and used for providing
funds in purchasing a new asset.
5. To Prevent the Distribution of Profits out of Capital: If the depreciation is not charged by
any company, the Profit and Loss A/c will show excess profit instead of actual profit. This
excess profit can be withdrawn by the owner or the shareholders of the company. Hence,
the amount distributed as profit includes some amount of depreciation which should not
happen.

How To Calculate Depreciation?

There are several methods for calculating depreciation, depending on whether your asset
depreciates at a constant rate or an accelerated rate. We’ll explore 5 of the most common
methods for how to calculate depreciation:

Straight-Line Depreciation

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The straight line method is one of the easiest ways to calculate constant depreciation. This is a
good formula to use for things like commercial and rental property, which typically depreciates
at a steady rate. The formula is:

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Annual Depreciation = (Asset Value – Salvage Value) / Useful Life in Years

Asset value is the cost or purchase price you initially paid for the asset

Salvage value is the amount you expect to be able to obtain for the asset at the end of its usable
life. Subtract salvage value from asset cost to get the total value that this asset will provide you
over its lifespan. Divide this by the estimated useful life in years to get the amount your asset

will depreciate every year.

Double-Declining Balance Depreciation

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The double-declining balance system calculates depreciation for an asset that depreciates at an
accelerated rate. The 2-step formula is as follows:

Double-Declining Balance Method Rate = (100% / Useful Life In Years) x 2

Depreciation = Depreciable Amount x Double-Declining Balance Method Rate

The ‘depreciable amount’ refers to the cost of your asset. This formula will give you greater
annual depreciation at the beginning portion of the asset’s useful life, with gradually declining
amounts each year until you reach the salvage value.

Sum-of-Years-Digits Depreciation

Sum-of-years-digits is another accelerated depreciation method that gives greater annual

depreciation in an asset’s early years.

Annual Depreciation = Depreciable Base x (Inverse Year Number / Sum of Year Digits)

‘Depreciable base’ is the total expected value of the asset. If your asset has no salvage value then
this is the amount that you paid for the asset. If it has a salvage value, then the depreciable base
is the amount you paid minus the salvage value.

To get the sum of year digits, add together all the digits of the asset’s expected life. For example,
an asset with a 5-year life would give you 5 + 4 + 3 + 2 + 1 = 15.

Inverse year number is the first year of expected life, starting from the greatest digit, divided by
the total years. In year 1 this would be (5 / 15), in year 2 it would be (4 / 15), and so on.

Units of Production Depreciation

The units of production method is helpful for assets whose usable life depends on the output
they produce, rather than on a continuous rate. This includes things like vehicles, which decline
more rapidly in years when you drive a lot. The formula is:

Depreciation = (Number of Units Consumed / Total Units To Be Consumed) x Depreciable

Base

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Total units to be consumed is the amount of value you expect from the asset, measured in units.
For example, if you purchase a machine and you expect it to make 100,000 products, you would
have 100,000 total units to consume.

Number of units consumed is the amount that you used in a given year—in this case, perhaps
your machine produced 30,000 products, so you would have used 30,000 units.

Modified Accelerated Cost Recovery System (MACRS)

The Modified Accelerated Cost Recovery System, or MACRS, is another method for
calculating accelerated depreciation. This works well for vehicles, equipment, and other physical
assets, but it cannot be used for intangible assets. The General Depreciation System (GDS) is the
most common method for calculating MACRS.

The IRS has 9 property classes for depreciable assets. Find the recovery period of your asset
from the IRS classifications in IRS Chapter 4 1and your asset’s depreciable base, then consult
IRS Publication 946 Appendix A to find the MACRS depreciation rate. MACRS calculations
tend to be a more complicated method for calculating depreciation and may benefit from the
support of a tax professional.

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Which Assets Can You Depreciate?

In general, for an asset to qualify as a depreciable property it must be something you own in its
entirety and use exclusively for your business or income. The following assets can be
depreciated:

Property

If you own a building that you use to make income, you can claim the depreciation on this
property. This includes rental properties as well as commercial buildings. If you work from
home, you may also be able to claim depreciation on the part of your home that you use
exclusively for business, such as a home office.

Note that you cannot claim depreciation on land, as it is not considered to wear out.

Vehicles and Equipment

If you use a vehicle or piece of equipment exclusively for business, you can claim depreciation
on that asset. However, if you drive a car for work and for personal use, you can only claim
depreciation on the business portion of your tax return (for example 60% of the cost).

Intangible Assets

Some purchased intangible property can be amortised, including:

 Patents and copyrights

 Readily available and non-exclusive computer software

Internally developed intangible assets are expensed as incurred (R&D costs).

What Is a Depreciation Schedule?

A depreciation schedule is a schedule that measures the decline in the value of a fixed asset over
its usable life. This helps you track where you are in the depreciation process and how much of
the asset’s value remains.

Your depreciation schedule will vary slightly depending on which calculation method you use.
In general, a depreciation schedule will contain 3 columns:

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 Column 1: Record the depreciation you expect the asset to incur each year. For the
fixed-line method and other continuous depreciation methods, this number is the same every
year.

 Column 2: Records the accumulated depreciation at the end of every year

 Column 3: Shows the asset’s net book value at the end of every year

Is depreciation an expense or income?

Depreciation is listed as an expense on your income statement since it represents part of the asset
cost allocated to the period. It’s not an asset or a liability itself, but rather an accounting tool
used to measure the change in value of an asset.

Is depreciation a good or bad thing?

Depreciation can be helpful because it enables a business to spread out the cost of an asset over
the asset’s usable life. Depreciation allows you to reduce your taxable income by claiming
depreciation as an expense, minimising your total tax bill.

How much depreciation can I claim?

The amount of depreciation you can claim in a given year depends upon your taxable income
and the dollar limit for the depreciating asset. In most cases, you can claim all the depreciation
of an asset as long as you allocate it over the asset’s life.

What is an example of a depreciation?

An example of depreciation would be a vehicle that declines in value as you drive it. The longer
you own it and the more you drive it, the more wear and tear the vehicle receives until it
eventually reaches the end of its usable life.

What happens if you don’t depreciate?

If you don’t depreciate your asset, you won’t be able to claim the full benefit of the depreciation
tax deduction. This deduction relies on claiming annual depreciation—since you can’t claim the
full depreciation amount all in one year, you’ll lose out on potential tax benefits.

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Additionally, you will fail to properly allocate the cost of your asset over its useful life.

Advantages and disadvantages of using straight-line method

Advantages
 It is easy to calculate and understand

 It provides a steady, predictable depreciating expense

 It is useful for assets that have a consistent decline in value over time

Disadvantages
 It may not accurately reflect the actual decline in value of the asset over time

 It may result in a higher or lower book value of the asset compared to its fair market
value

 It may not be the best method for assets that have a higher rate of decline in value in
the earlier years of their life

Advantages and disadvantages of using double-declining balance method

Advantages
 It provides a higher depreciation expense in the earlier years of the asset’s life when it
is typically more productive and valuable

 It can more accurately reflect the decline in value of an asset over time compared to
straight-line method

 It can help businesses better plan for future expenses

Disadvantages
 It may result in a lower book value of the asset compared to its fair market value in
later years

 It may not be appropriate for assets that have a more consistent rate of decline in
value over their useful life

 It can be more complex to calculate and understand compared to straight-line formula

Advantages and disadvantages of using sum-of-the-years’ digits method

Advantages
 It allocates a higher depreciation expense to the earlier years of an asset’s useful life,
reflecting the fact that assets generally lose more value in their earlier years

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 It can provide a more accurate reflection of an asset’s decline in value over time
compared to straight-line method

 It can help businesses better plan for future expenses

Disadvantages
 It can be more complex to calculate and understand compared to straight-line formula

 It may result in a lower book value of the asset compared to its fair market value in
later years

 It may not be appropriate for assets that have a more consistent rate of decline in
value over their useful life.

Advantages and disadvantages of using Units of Production method

Advantages
 It provides a more accurate reflection of an asset’s decline in value over time based on
actual usage or production

 It can help businesses better plan for future expenses

 It may result in a higher book value of the asset compared to its fair market value in
later years

Disadvantages
 It can be more complex to calculate and understand compared to straight-line

 It may result in greater fluctuations in depreciating expense from period to period

based on usage or production

 It may not be appropriate for assets that have a more consistent rate of decline in
value over their useful life.

Conclusion

Depreciation refers to the systematic allocation of the cost of a tangible asset over its useful
life. It represents the reduction in value of an asset due to wear and tear, obsolescence, or age.
Depreciation is a non-cash expense that is recorded on the income statement, reducing the
reported earnings, while also reducing the book value of the asset on the balance sheet. It is
an important accounting concept that helps businesses match the cost of using an asset with
the revenue it generates over time. Different methods of depreciation, such as straight-line,
declining balance, and units of production, allow businesses to align the expense recognition

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with the pattern of economic benefits derived from the asset. Properly accounting for
depreciation is essential for accurate financial reporting, tax compliance, and informed
decision-making regarding asset management and replacement.

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Bibliography

 www.bench.co : Bench Accounting

 https://corporatefinanceinstitute.com/resources/accounting/types-depreciation-
methods/ : Corporate Finance Institute
 https://stripe.com/in/resources/more/afa-germany : Stripe
 https://efinancemanagement.com/financial-accounting/depreciation : efinance
management
 https://www.irs.gov/pub/irs-regs/depreciation_faqs_v2.pdf : Depreciation pdf
 https://www.xero.com/guides/what-is-depreciation/ : Zero
 https://incometaxindia.gov.in/Pages/tools/depreciation-plant-machinery-
calculator.aspx : CBDT

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