Q.On January 01, 2014, a Limited Company purchased machinery for ₹ 20,00,000. Depreciation is provided @15% p.a. on diminishing balance method. On March 01, 2016, one fourth of machinery was damaged by fire and ₹ 40,000 were received from the insurance company in full settlement. On September 01, 2016 another machinery was purchased by the company for ₹ 15,00,000.
Write up the machinery account from 2010 to 2013. Books are closed on December 31, every year.

Depreciation Accounting — A First Look

Think about a new smartphone you buy for ₹50,000. After two years, if you try to sell it, you'll be lucky to get ₹20,000. The phone hasn't changed physically — it still works, it still makes calls — but its value has fallen. That fall in value is depreciation.

Now scale that up. A business buys a delivery van for ₹8,00,000. The van will be used for five years. At the end of five years, it might be sold as scrap for ₹50,000. The business knows, right from day one, that the van is losing value every year it is used. Depreciation accounting is simply the systematic way of recording that loss of value each year.

The precise meaning

Depreciation is the permanent, continuous, and gradual reduction in the book value of a fixed asset. It applies to tangible fixed assets — machinery, buildings, furniture, vehicles, computers — that have a useful life of more than one accounting period. Land is the major exception: land does not depreciate (unless it is a mine or quarry).

Three things cause depreciation:

• Wear and tear from use (a machine running 16 hours a day wears out faster)
• Passage of time even if unused (a car parked in a garage still loses value)
• Obsolescence (a computer becomes outdated long before it physically breaks)

Why does it matter?

If a business does not record depreciation, its profit will be overstated. Imagine a transport company that earns ₹10,00,000 in a year and spends ₹6,00,000 on fuel, salaries, and repairs. If it ignores the fact that its buses lost ₹2,00,000 in value, it will report a profit of ₹4,00,000. But the true profit — after accounting for the wearing out of buses — is only ₹2,00,000. The business is actually poorer than it looks.

Depreciation also ensures that the asset's cost is spread over the years it helps generate revenue. This is the matching principle in action: expenses should be recorded in the same period as the revenue they help earn.

The accounting treatment

There are two accounts involved in every depreciation entry:

1. Depreciation Account — an expense account (nominal account)
2. Asset Account — the fixed asset account (real account)

The journal entry is:

Why this entry? Depreciation is an expense, so we debit the Depreciation Account (increase in expense). The asset's value is falling, so we credit the Asset Account (decrease in asset).

At the end of the year, the Depreciation Account is closed by transferring it to the Profit & Loss Account:

The Asset Account now shows a reduced balance — this is called the book value or written down value of the asset.

The two main methods

Straight Line Method (SLM)

Under this method, an equal amount of depreciation is charged every year over the asset's useful life.

Formula:

Depreciation per year = (Cost of asset – Estimated scrap value) ÷ Estimated useful life

Example: A machine costs ₹1,00,000, scrap value ₹10,000, useful life 5 years.

Depreciation per year = (1,00,000 – 10,000) ÷ 5 = ₹18,000 each year.

The asset's book value falls by a fixed amount every year — a straight line on a graph.

Written Down Value Method (WDV)

Under this method, depreciation is charged at a fixed rate on the reducing balance of the asset each year.

Formula:

Depreciation for the year = Book value at the beginning of the year × Rate of depreciation

Example: Same machine ₹1,00,000, rate 20% p.a.

Year 1: 1,00,000 × 20% = ₹20,000

Year 2: (1,00,000 – 20,000) × 20% = 80,000 × 20% = ₹16,000

Year 3: (80,000 – 16,000) × 20% = 64,000 × 20% = ₹12,800

The depreciation amount keeps falling each year, but the rate stays constant.