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Imagine you buy a new smartphone for INR 30,000. Over time, it becomes less valuable because it gets old, slower, or newer models come out. This loss in value over time is what we call depreciation when it comes to assets in accounting.
In financial accounting, depreciation is the process of allocating the cost of a tangible asset over its useful life. This is important because assets like machinery, vehicles, or computers don't last forever, and their value decreases as they are used.
Why do we account for depreciation? Because it helps businesses match the cost of using an asset with the revenue it generates each year. This matching principle ensures that financial statements show a realistic picture of profits and asset values.
The Straight Line Method is the simplest and most commonly used way to calculate depreciation. Here, the asset loses the same amount of value every year until it reaches its residual (or salvage) value.
This method assumes the asset's usefulness and wear are consistent over time.
Let's see how this works with an example:
| Year | Annual Depreciation (INR) | Accumulated Depreciation (INR) | Book Value at Year-End (INR) |
|---|---|---|---|
| 0 (Purchase) | - | 0 | 1,00,000 |
| 1 | 20,000 | 20,000 | 80,000 |
| 2 | 20,000 | 40,000 | 60,000 |
| 3 | 20,000 | 60,000 | 40,000 |
| 4 | 20,000 | 80,000 | 20,000 |
| 5 | 20,000 | 1,00,000 | 0 |
Unlike SLM, the Reducing Balance Method charges depreciation on the asset's book value at the beginning of each year, not the original cost. This means depreciation is higher in the early years and decreases over time.
This method reflects the reality that many assets lose value faster when they are new.
Example of depreciation schedule under RBM:
| Year | Opening Book Value (INR) | Depreciation @ 20% (INR) | Closing Book Value (INR) |
|---|---|---|---|
| 0 (Purchase) | - | - | 1,00,000 |
| 1 | 1,00,000 | 20,000 | 80,000 |
| 2 | 80,000 | 16,000 | 64,000 |
| 3 | 64,000 | 12,800 | 51,200 |
| 4 | 51,200 | 10,240 | 40,960 |
| 5 | 40,960 | 8,192 | 32,768 |
The Sum of Years' Digits method is an accelerated depreciation technique. It allocates higher depreciation in the earlier years and less in later years, but in a more gradual way than RBM.
The depreciation expense each year is based on a fraction where the numerator is the remaining life of the asset and the denominator is the sum of the years' digits.
For example, for a 4-year asset, the sum of years digits is:
\[ 4 + 3 + 2 + 1 = \frac{4 \times (4+1)}{2} = 10 \]
| Year | Remaining Life | Fraction | Depreciation Amount (INR) |
|---|---|---|---|
| 1 | 4 | 4/10 | 48,000 |
| 2 | 3 | 3/10 | 36,000 |
| 3 | 2 | 2/10 | 24,000 |
| 4 | 1 | 1/10 | 12,000 |
This method calculates depreciation based on the asset's actual usage or output, rather than time. It is ideal for manufacturing equipment or vehicles where wear depends on how much the asset is used.
Example depreciation calculation based on units produced:
| Year | Units Produced | Depreciation per Unit (INR) | Depreciation Expense (INR) |
|---|---|---|---|
| 1 | 20,000 | 2 | 40,000 |
| 2 | 25,000 | 2 | 50,000 |
| 3 | 30,000 | 2 | 60,000 |
Step 1: Calculate annual depreciation using the formula:
\[ \text{Depreciation Expense} = \frac{Cost - Residual\ Value}{Useful\ Life} = \frac{1,00,000 - 0}{5} = 20,000 \text{ INR} \]
Step 2: Calculate accumulated depreciation and book value for each year:
| Year | Annual Depreciation (INR) | Accumulated Depreciation (INR) | Book Value (INR) |
|---|---|---|---|
| 1 | 20,000 | 20,000 | 80,000 |
| 2 | 20,000 | 40,000 | 60,000 |
| 3 | 20,000 | 60,000 | 40,000 |
| 4 | 20,000 | 80,000 | 20,000 |
| 5 | 20,000 | 1,00,000 | 0 |
Answer: Annual depreciation is INR 20,000 each year, with book value reducing to zero after 5 years.
Step 1: Calculate depreciation for each year using:
\[ \text{Depreciation} = \text{Book Value}_{beginning} \times 20\% \]
Step 2: Year-wise calculations:
| Year | Opening Book Value (INR) | Depreciation (INR) | Closing Book Value (INR) |
|---|---|---|---|
| 1 | 1,00,000 | 20,000 | 80,000 |
| 2 | 80,000 | 16,000 | 64,000 |
| 3 | 64,000 | 12,800 | 51,200 |
| 4 | 51,200 | 10,240 | 40,960 |
| 5 | 40,960 | 8,192 | 32,768 |
Answer: Depreciation decreases each year as it is calculated on the reducing book value.
Step 1: Calculate sum of years digits:
\[ \text{Sum} = \frac{4 \times (4+1)}{2} = 10 \]
Step 2: Calculate depreciation for each year using:
\[ \text{Depreciation} = (1,20,000 - 0) \times \frac{\text{Remaining Life}}{10} \]
Step 3: Year-wise depreciation:
| Year | Remaining Life | Depreciation (INR) |
|---|---|---|
| 1 | 4 | 1,20,000 x 4/10 = 48,000 |
| 2 | 3 | 1,20,000 x 3/10 = 36,000 |
| 3 | 2 | 1,20,000 x 2/10 = 24,000 |
| 4 | 1 | 1,20,000 x 1/10 = 12,000 |
Answer: Depreciation expenses are INR 48,000, 36,000, 24,000, and 12,000 for years 1 to 4 respectively.
Step 1: Calculate depreciation per unit:
\[ \text{Depreciation per Unit} = \frac{2,00,000 - 0}{1,00,000} = 2 \text{ INR/unit} \]
Step 2: Calculate depreciation for 20,000 units produced:
\[ \text{Depreciation Expense} = 2 \times 20,000 = 40,000 \text{ INR} \]
Answer: Depreciation expense for the first year is INR 40,000.
Step 1: Calculate SLM depreciation:
\[ \text{Annual Depreciation} = \frac{1,50,000 - 0}{5} = 30,000 \text{ INR} \]
Step 2: SLM schedule:
| Year | Depreciation (INR) | Accumulated Depreciation (INR) | Book Value (INR) |
|---|---|---|---|
| 1 | 30,000 | 30,000 | 1,20,000 |
| 2 | 30,000 | 60,000 | 90,000 |
| 3 | 30,000 | 90,000 | 60,000 |
Step 3: Calculate RBM depreciation:
Year 1:
\[ 1,50,000 \times 20\% = 30,000 \]
Book value end of Year 1 = 1,50,000 - 30,000 = 1,20,000
Year 2:
\[ 1,20,000 \times 20\% = 24,000 \]
Book value end of Year 2 = 1,20,000 - 24,000 = 96,000
Year 3:
\[ 96,000 \times 20\% = 19,200 \]
Book value end of Year 3 = 96,000 - 19,200 = 76,800
Step 4: RBM schedule:
| Year | Depreciation (INR) | Book Value End (INR) |
|---|---|---|
| 1 | 30,000 | 1,20,000 |
| 2 | 24,000 | 96,000 |
| 3 | 19,200 | 76,800 |
Answer: SLM charges equal depreciation of INR 30,000 each year, while RBM charges higher depreciation initially that decreases over time, resulting in higher book values in later years.
| Feature | Straight Line Method (SLM) | Reducing Balance Method (RBM) | Sum of Years' Digits (SYD) | Units of Production |
|---|---|---|---|---|
| Depreciation Pattern | Equal each year | Higher early years, decreases later | Accelerated, decreases over time | Based on actual usage |
| Complexity | Simple | Moderate | Moderate | Requires usage data |
| Best For | Assets with consistent use | Assets losing value quickly | Assets with faster early wear | Production-based assets |
| Residual Value Considered | Yes | Usually ignored or minimal | Yes | Yes |
| Effect on Profit | Steady expense | Higher expense early, lower later | Higher early expense | Variable expense |
When to use: During exam preparation and solving numerical problems.
When to use: When calculating depreciation for multiple years using RBM.
When to use: When using SYD method to speed up fraction calculations.
When to use: When depreciation depends on asset usage or output.
When to use: When deciding which method to apply or for conceptual clarity.
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