Meaning of Depreciation

Depreciation is not a loss of market value. It is a permanent, continuing, and gradual shrinkage in the book value of fixed assets. The key idea is that a fixed asset — a machine, a building, a vehicle — gives service to the business over several years. Each year, a part of its cost is "used up." Depreciation is the accounting way of recognising that consumption.

The cost that is allocated is based on what the business paid for the asset, not on what it could be sold for today. Market fluctuations are ignored; the focus is on spreading the historical cost over the asset's useful life.

Definitions from authoritative bodies

Two formal definitions are given, and you should be comfortable with both.

The Institute of Cost and Management Accounting, London (ICMA) describes depreciation as "the diminution in intrinsic value of the asset due to use and/or lapse of time." This highlights the two main causes: using the asset wears it out, and even if it sits idle, time itself can reduce its value.

The more detailed definition comes from Accounting Standard-6 (AS-6) issued by the Institute of Chartered Accountants of India (ICAI). AS-6 states that depreciation is "a measure of the wearing out, consumption or other loss of value of a depreciable asset arising from use, effluxion of time or obsolescence through technology and market-change."

This means depreciation is not a one-time adjustment. It is a systematic allocation of cost across the periods that benefit from the asset's use. The term "amortisation" is used for intangible assets (like patents or copyrights) that have a fixed life, but the principle is the same.

What is a "Depreciable Asset"?

Not every asset is depreciated. AS-6 defines a depreciable asset as one that meets all three of these conditions:

• It is expected to be used for more than one accounting period.
• It has a limited useful life.
• It is held by the enterprise for use in production, supply of goods/services, rental, or administration — not for sale in the ordinary course of business.

Common examples include: machinery, plant, furniture, buildings, computers, trucks, vans, and equipment. Land is not depreciated because it has an unlimited useful life.

The Three Factors That Determine Depreciation

The amount of depreciation charged each year depends on three things:

1. Cost of the Asset: This is not just the purchase price. It includes all costs spent on acquisition, installation, and commissioning, plus any subsequent additions or improvements. The total of these is the "historical cost."
2. Useful Life of the Asset: This is the period over which the enterprise expects to use the asset. It can be measured in years or in the number of production units expected from the asset.
3. Net Realisable Value (Salvage Value / Scrap Value): This is the estimated amount the business expects to receive when the asset is eventually sold or scrapped at the end of its useful life.

This is the total amount that must be allocated as depreciation over the asset's useful life.

The Two Main Methods of Depreciation

The textbook introduces two primary methods for calculating the annual depreciation charge:

• Straight Line Method (SLM): A fixed, equal amount of depreciation is charged every year.
• Written Down Value Method (WDV): A fixed percentage of the asset's book value (cost minus accumulated depreciation) is charged each year. The amount of depreciation decreases over time.

The choice of method depends on the type of asset, the nature of its use, and the circumstances of the business. Once a method is selected, it should be applied consistently from year to year. A change in method is allowed only under specific, justified circumstances.

The Accounting Treatment (Journal Entry)

Depreciation is an expense. It reduces the profit of the business and also reduces the value of the asset on the balance sheet. The journal entry to record depreciation is: