How to Calculate Depreciation: Methods, Formulas, and Practical Examples
Depreciation is an important accounting concept in Commerce. It describes the process of allocating the cost of a tangible asset over its useful life. This approach helps businesses record the gradual decrease in value of fixed assets, such as machinery, equipment, and buildings, as they are used in operations. Depreciation does not apply to land because land is considered to have an indefinite useful life.
Meaning and Importance of Depreciation
Depreciation ensures that the cost of an asset is not recognized as an expense all at once but is spread across the periods it provides economic benefits. This matches the asset’s expense with the revenue it helps generate, following the matching principle in accounting. Recognizing depreciation also gives a more accurate view of the company's financial position, aids in asset replacement planning, and provides certain tax benefits because depreciation is typically a deductible expense.
Key Terms in Depreciation
- Tangible Asset:
Physical property, like machinery, vehicles, and buildings, that is expected to last more than one year.
- Useful Life:
The period during which the asset is expected to be productive for business use. It may differ from its physical lifespan.
- Cost:
The purchase price plus all expenses required to get the asset ready for use (installation, shipping, etc.).
- Salvage Value (Residual Value):
Estimated amount to be received when the asset is disposed or sold at the end of its useful life.
- Depreciable Base:
The total cost to be depreciated, calculated as: Cost – Salvage Value.
- Accumulated Depreciation:
The total depreciation charged on an asset since its acquisition.
- Book Value (Carrying Value):
Asset's original cost minus accumulated depreciation, showing its net value on the balance sheet.
Basic Depreciation Formula
The most common method to calculate annual depreciation is the Straight-Line Method:
Depreciation per year = (Cost of Asset – Salvage Value) / Useful Life
Example: Straight-Line Depreciation
Suppose a machine costs ₹50,000, has a salvage value of ₹5,000, and a useful life of 5 years.
Depreciable base = ₹50,000 – ₹5,000 = ₹45,000
Annual depreciation = ₹45,000 ÷ 5 = ₹9,000 per year
| Year | Opening Value (₹) | Depreciation (₹) | Closing Book Value (₹) |
|---|---|---|---|
| 1 | 50,000 | 9,000 | 41,000 |
| 2 | 41,000 | 9,000 | 32,000 |
| 3 | 32,000 | 9,000 | 23,000 |
| 4 | 23,000 | 9,000 | 14,000 |
| 5 | 14,000 | 9,000 | 5,000 |
Other Depreciation Methods
| Method | Formula | Description |
|---|---|---|
| Straight-Line | (Cost – Salvage Value) / Useful Life | Equal expense every year |
| Declining Balance | Book Value × Rate (%) | Higher expense in earlier years, decreases with time |
| Double Declining Balance | Book Value × (2 × Straight-Line Rate) | Accelerated method, expense drops quickly |
| Sum-of-Years’ Digits | (Depreciable Base) × (Remaining Life / Sum of Years) | Front-loads the expense |
| Units of Production | Depreciable Base / Estimated Output × Actual Output | Based on asset usage |
Sample Calculation: Declining Balance Method
For the same machine (Cost: ₹50,000, Salvage Value: ₹5,000, Useful Life: 5 years, Rate: 20%):
- Year 1: ₹50,000 × 20% = ₹10,000
- Year 2: ₹40,000 × 20% = ₹8,000
- Year 3: ₹32,000 × 20% = ₹6,400
Note: In this method, depreciation is applied to the reduced book value each year.
Key Points on Depreciation and Taxes
- Only assets owned and used for business purposes are eligible for depreciation.
- Depreciation lowers taxable income, providing tax relief to businesses.
- Intangible assets (like patents) are not depreciated but amortized.
Applications and Practical Approach
- Calculate depreciable base as Cost – Salvage Value.
- Choose a suitable method according to the asset type and usage pattern.
- Apply the relevant formula to determine the depreciation expense each period.
- Track accumulated depreciation and update book value each year.
Summary Table: Depreciation Analysis
| Term | Meaning |
|---|---|
| Carrying Value | Original cost minus accumulated depreciation |
| Depreciation Rate | Annual percentage applied to depreciable base |
| Accumulated Depreciation | Total depreciation charged till date |
To master depreciation and other Commerce topics, practice a variety of problems and review your core concepts. For more resources and guidance, refer to Vedantu’s structured study materials and commerce principle guides.
FAQs on Understanding Depreciation in Commerce: Definition, Methods & Calculation
1. What is depreciation?
Depreciation is the systematic reduction in the recorded value of a tangible fixed asset over its useful life due to wear and tear, obsolescence, or passage of time. It helps allocate the cost of an asset for accounting and tax purposes. Depreciation ensures that expense recognition matches asset usage and revenues earned.
3. What assets can be depreciated?
Depreciable assets are tangible fixed assets used in business that:
- Have a useful life of more than one year
- Are owned (not leased)
- Are used for business or income generation
- Include machinery, vehicles, equipment, buildings (excluding land)
7. What is residual value or salvage value in depreciation?
Residual value (or salvage value) is the estimated amount expected to be realized at the end of an asset's useful life, after its full use. It is deducted from the asset's cost to calculate the depreciable amount.
9. Can land be depreciated?
No, land is not depreciated because it does not have a limited useful life and generally does not wear out or get consumed in business operations.
10. How does depreciation affect profit and loss statements?
Depreciation is a non-cash expense shown in the profit and loss account. It reduces the net profit but does not involve actual cash outflow, ensuring correct periodic matching of asset expense and revenue.
11. What is a depreciation schedule?
A depreciation schedule is a table that shows the yearly calculation of:
- Opening asset value
- Annual depreciation
- Closing asset value at year end
12. What is accumulated depreciation?
Accumulated depreciation is the total depreciation charged on an asset since its acquisition till the reporting date. It is subtracted from the asset's original cost to determine the carrying or book value on the balance sheet.
