A business may buy a machine today but use it for the next five or ten years. Recording its entire cost as an expense in the year of purchase would not reflect how the asset is actually used.
Depreciation solves this by spreading the depreciable amount of a tangible asset over its useful life. It helps businesses calculate profit more appropriately, track the carrying value of assets and account for the cost of using long-term assets over time.
What is Depreciation?
Depreciation is the systematic allocation of the depreciable amount of a tangible asset over its useful life.
Instead of recording the entire cost of a long-term asset as an expense immediately, a business recognises part of that cost over the periods in which the asset is used.
For example, if a machine costs ₹1,00,000, has a residual value of ₹10,000 and is expected to be used for five years, the depreciable amount is ₹90,000. Under the straight-line method, ₹18,000 would be charged as depreciation each year.
Depreciation commonly applies to assets such as machinery, buildings, furniture, computers, office equipment and vehicles.
Why Do Assets Depreciate?
Assets can lose their economic usefulness for several reasons:
- Wear and tear: Machinery, equipment and vehicles deteriorate with regular use.
- Technological obsolescence: Computers and electronic equipment may become outdated even when they still work.
- Commercial obsolescence: Changes in demand or business requirements may reduce the usefulness of an asset.
- Time: Some assets have a limited period during which they can be used economically.
- Usage: Assets used more intensively may consume their economic benefits faster.
An asset's useful life therefore depends on how the business expects to use it, rather than simply how long the asset can physically survive.
Why is Depreciation Important for Businesses?
1. It allocates asset cost across its useful life
A long-term asset may support business operations for several years. Depreciation allocates its depreciable amount across those years instead of recognising the entire amount at once.
2. It affects reported profit
Depreciation is recorded as an expense. A higher depreciation charge reduces accounting profit for that period, while a lower charge results in higher accounting profit, all else being equal.
3. It reduces the carrying amount of an asset
Depreciation accumulates over time and reduces the amount at which the asset is carried in the financial statements.
The carrying amount should not be confused with market value. An asset's market price can be higher or lower than its carrying amount.
4. It supports asset planning
A fixed asset register and depreciation schedule help finance teams track asset cost, accumulated depreciation, remaining useful life and carrying amount. This information can support decisions about maintenance, replacement and future capital expenditure.
5. It can affect taxable income
Tax laws may allow eligible businesses to claim depreciation as a deduction. Tax depreciation follows statutory rules and may differ from the depreciation recorded in financial statements.
How to Calculate Depreciation
Before calculating depreciation, you need four pieces of information.
1. Cost of the Asset
Asset cost generally includes the purchase price and directly attributable costs required to bring the asset to the location and condition necessary for its intended use.
For example:
Machine purchase price: ₹1,00,000
Installation cost: ₹5,000
Total asset cost: ₹1,05,000
Applicable accounting rules should be considered when deciding which taxes and other costs form part of the asset's cost.
2. Residual Value
Residual value, sometimes called salvage or scrap value, is the estimated amount a business expects to receive from disposing of the asset at the end of its useful life, after considering applicable disposal costs.
Suppose the asset costs ₹1,05,000 and its estimated residual value is ₹10,000.
Depreciable amount = ₹1,05,000 − ₹10,000 = ₹95,000
3. Useful Life
Useful life refers to the period for which the asset is expected to be available for use by the business or the number of production or similar units expected to be obtained from it.
Useful life can depend on usage, maintenance, technological changes, commercial obsolescence and legal restrictions.
4. Depreciation Method
The depreciation method should reflect how the asset's economic benefits are expected to be consumed.
Common methods include straight-line, written down value or diminishing balance, and units of production.
Types of Depreciation Methods
Different assets may consume their economic benefits differently. That is why businesses use different methods of depreciation.
1. Straight-Line Method of Depreciation
The Straight-Line Method, or SLM, charges an equal amount of depreciation in each year of an asset's useful life, assuming the residual value does not change.
Formula:
Annual Depreciation = (Cost of Asset − Residual Value) ÷ Useful Life
Example
Suppose a machine has:
Cost: ₹1,00,000
Residual value: ₹10,000
Useful life: 5 years
Annual depreciation:
(₹1,00,000 − ₹10,000) ÷ 5 = ₹18,000
The business records ₹18,000 as depreciation each year.
| Year | Opening Carrying Amount | Depreciation | Closing Carrying Amount |
|---|
| 1 | ₹1,00,000 | ₹18,000 | ₹82,000 |
| 2 | ₹82,000 | ₹18,000 | ₹64,000 |
| 3 | ₹64,000 | ₹18,000 | ₹46,000 |
| 4 | ₹46,000 | ₹18,000 | ₹28,000 |
| 5 | ₹28,000 | ₹18,000 | ₹10,000 |
SLM can be suitable when an asset provides relatively consistent economic benefits throughout its useful life.
2. Written Down Value Method
The Written Down Value method, also called the diminishing balance or declining balance method, applies a fixed depreciation rate to the asset's opening carrying amount.
As the carrying amount decreases, the depreciation charge also decreases.
Formula:
Depreciation = Opening Written Down Value × Depreciation Rate
Suppose an asset costs ₹1,00,000 and the applicable rate is 20%.
Year 1:
₹1,00,000 × 20% = ₹20,000 depreciation
Closing WDV = ₹80,000
Year 2:
₹80,000 × 20% = ₹16,000 depreciation
Closing WDV = ₹64,000
The method results in a higher depreciation charge during the earlier years and a lower amount later.
3. Units of Production Method
The units of production method bases depreciation on actual usage or output rather than simply the passage of time.
Formula:
Depreciation per Unit = (Asset Cost − Residual Value) ÷ Estimated Total Units
Depreciation for the Period = Depreciation per Unit × Units Produced
Suppose a machine costs ₹5,00,000, has a residual value of ₹50,000 and is expected to manufacture 1,00,000 units.
Depreciation per unit:
(₹5,00,000 − ₹50,000) ÷ 1,00,000 = ₹4.50
If it produces 20,000 units during the year:
₹4.50 × 20,000 = ₹90,000
This method can suit machinery whose consumption is closely linked to production.
4. Double Declining Balance Method
Double declining balance is an accelerated depreciation method. It generally applies twice the straight-line depreciation rate to the asset's opening carrying amount. If an asset has a useful life of five years, the straight-line rate would be 20%. The double declining rate would therefore be 40%. The calculation is then made on the reducing carrying amount.
5. Sum-of-the-Years Digits Method
Sum-of-the-Years' Digits, or SYD, is another accelerated method that records more depreciation during the earlier years of an asset's useful life.
For an asset with a five-year useful life:
5 + 4 + 3 + 2 + 1 = 15
In the first year, the depreciation fraction is 5/15. In the second year, it becomes 4/15, followed by 3/15, 2/15 and 1/15. The fraction is applied to the asset's depreciable amount.
Straight-Line vs Written Down Value Method
| Basis | Straight-Line Method | Written Down Value Method |
|---|
| Depreciation amount | Usually constant each year | Decreases each year |
| Calculation base | Depreciable amount | Opening written down value |
| Early-year expense | Lower than accelerated methods | Higher |
| Later-year expense | Remains constant | Lower |
| Suitable when | Economic benefits are consumed evenly | Greater benefits are consumed earlier |
The appropriate accounting method should reflect the expected pattern in which the asset's economic benefits will be consumed.
What is Accumulated Depreciation?
Accumulated depreciation is the total depreciation recorded on an asset from the date depreciation begins up to a particular reporting date. Suppose a machine originally cost ₹1,00,000 and the business has recorded ₹18,000 of depreciation each year for three years.
Accumulated depreciation after three years:
₹18,000 × 3 = ₹54,000
If there are no other adjustments:
Carrying amount = ₹1,00,000 − ₹54,000 = ₹46,000
Accumulated depreciation therefore represents depreciation recorded to date, while depreciation expense refers to the amount recognised for a particular accounting period.
How Does Depreciation Affect Financial Statements?
Depreciation mainly affects the income statement and balance sheet. On the income statement, depreciation is recorded as an expense and generally reduces accounting profit. On the balance sheet, accumulated depreciation reduces the carrying amount of the related asset.
Depreciation is a non-cash expense. Recording depreciation does not require a new cash payment during that accounting period. The cash outflow usually occurred when the asset was originally purchased.
Book Depreciation vs Tax Depreciation in India
Book depreciation and tax depreciation serve different purposes.
Book depreciation is used for preparing financial statements and follows the accounting framework applicable to the business.
Tax depreciation is used when calculating taxable business income and follows the rules prescribed under income-tax law.
The method, asset grouping, useful life and depreciation amount used for financial reporting may therefore differ from the amount allowed for tax purposes.
Depreciation Under the Companies Act, 2013
For companies, Schedule II of the Companies Act, 2013 provides useful lives for different classes of tangible assets. It defines depreciation as the systematic allocation of the depreciable amount of an asset over its useful life.
The depreciable amount is:
Cost of Asset − Residual Value
Schedule II states that an asset's useful life should ordinarily follow the useful life specified in the Schedule. Its residual value should ordinarily not exceed 5% of the original cost unless a different estimate is justified and appropriately disclosed.
Companies must also consider the applicable accounting standards, including AS 10 or Ind AS 16, depending on the financial reporting framework that applies to them.
Depreciation Under the Income-tax Act, 2025
India's Income-tax Act, 2025 came into force on 1 April 2026 and replaced the Income-tax Act, 1961 for Tax Year 2026-27 onward. Section 33 of the Income-tax Act, 2025 deals with deduction for depreciation.
For most eligible business assets, tax depreciation is calculated using prescribed percentages on the written down value of a block of assets. Assets are grouped into blocks according to their class and prescribed depreciation rate.
The law covers eligible tangible assets such as buildings, machinery, plant and furniture, as well as specified intangible assets.
Where an eligible asset is acquired during the tax year and put to use for less than 180 days, the depreciation deduction is generally restricted to 50% of the prescribed rate, subject to the applicable provisions.
For periods ending on or before 31 March 2026, the applicable provisions of the earlier Income-tax Act, 1961 continue to govern those periods.
Depreciation vs Amortisation
Depreciation and amortisation both allocate asset costs over time, but they are normally associated with different asset types.
| Basis | Depreciation | Amortisation |
|---|
| Asset type | Generally applies to tangible assets | Generally applies to intangible assets |
| Examples | Machinery and equipment | Patents and certain licences |
| Basis | Based on useful life or usage | Based on the useful life of the intangible asset |
| Recording | Recorded periodically | Recorded periodically |
The accounting treatment of an intangible asset depends on the applicable accounting standard and whether the asset has a finite or indefinite useful life.
Which Assets Can Be Depreciated?
Common depreciable tangible assets include:
- Buildings
- Machinery
- Plant and equipment
- Furniture
- Computers
- Office equipment
- Vehicles
Land is generally treated differently because it normally has an unlimited useful life and is therefore not depreciated.
However, land and buildings are accounted for separately. A building has a limited useful life and can be depreciated even when the land on which it stands is not.
Conclusion
Depreciation helps businesses allocate the cost of long-term assets across the periods in which those assets are used. The calculation depends on the asset's cost, residual value, useful life and depreciation method. Straight-line depreciation records a relatively constant charge, while written down value and other accelerated methods recognise higher depreciation during earlier periods.
For Indian businesses, it is also important to separate accounting depreciation from tax depreciation. Financial reporting follows applicable accounting standards and, for companies, the Companies Act framework, while tax depreciation follows the Income-tax Act and its prescribed rules.
FAQs
What is depreciation in simple words?
Depreciation means spreading the depreciable cost of a long-term tangible asset over the period in which the business expects to use it.
What is the basic formula for depreciation?
For the straight-line method:
Annual Depreciation = (Asset Cost − Residual Value) ÷ Useful Life
Is depreciation an expense?
Yes. Depreciation is generally recorded as an expense in the income statement. However, it is a non-cash expense because recording depreciation does not itself involve a cash payment.
What is accumulated depreciation?
Accumulated depreciation is the total depreciation recorded on an asset from the date depreciation begins up to the reporting date.
What is depreciable amount?
Depreciable amount is the cost of an asset, or another amount substituted for cost, minus its residual value.
Is land depreciated?
Land is generally not depreciated because it normally has an unlimited useful life. Buildings located on the land are accounted for separately and can be depreciated.
What is the difference between book value and market value?
The carrying or book value of an asset is based on its accounting records, generally after deducting accumulated depreciation and applicable impairment.
Market value refers to the amount for which the asset could potentially be sold in the market. The two amounts can differ significantly.
Can a company change its depreciation method?
For accounting purposes, the depreciation method should be reviewed periodically. Under applicable accounting standards, if the expected pattern in which the asset's economic benefits are consumed changes significantly, the depreciation method may need to be changed and the change is generally treated prospectively as a change in accounting estimate.
What are the main depreciation methods?
Common methods include the Straight-Line Method, Written Down Value or diminishing balance method, units of production method, double declining balance method and Sum-of-the-Years' Digits method.
Does depreciation reduce cash flow?
Depreciation itself does not involve a current cash outflow. However, an allowable tax depreciation deduction may reduce taxable income and therefore affect the amount of tax a business pays.
