Depreciation: Types, Methods & Accounting Treatment

TAKEAWAYS:

• Depreciation is the systematic allocation of an asset’s cost over its useful life due to wear and tear, obsolescence, or passage of time.
• Common methods include straight-line, reducing balance, and units of production—each suited for different asset types.
• Depreciation is recorded as an expense in the income statement and reduces the asset’s book value in the balance sheet.
• Disposal of depreciated assets involves calculating profit/loss on sale and updating depreciation records.
• Accelerated depreciation (e.g., reducing balance) is used for assets with higher early-year wear.
• NEB exams test numerical calculations, journal entries, and understanding why depreciation is necessary.

What is Depreciation?

Depreciation is the gradual loss in value of a fixed asset (like machinery, furniture, or vehicles) over time due to:

• Wear and tear (physical use).
• Obsolescence (becoming outdated).
• Passage of time (even if unused).

Why is it recorded?

• Fairness: Assets are not fully expensed in the year of purchase.
• Matching Principle: Expenses are matched with revenue earned using the asset.
• Tax Benefits: Governments allow depreciation deductions to reduce taxable income.

Key Terms

flowchart TD
    A["Asset Cost"] --> B["Book Value"]
    B --> C["Depreciable Amount"]
    C --> D["Depreciation Expense"]
    D --> E["Accumulated Depreciation"]
    E --> B

• Asset Cost: Original purchase price of the asset.
• Book Value: Cost – Accumulated Depreciation.
• Depreciable Amount: Cost – Residual Value (estimated scrap value at the end of the asset’s life).
• Accumulated Depreciation: Total depreciation charged over the asset’s life (a contra asset account).

Methods of Depreciation

Depreciation is calculated using different methods. The NEB exam often asks to compute depreciation using these methods.

1. Straight-Line Method (SLM)

The simplest method—equal depreciation every year.

Formula: $$\text{Annual Depreciation}=\frac{\text{Cost}-\text{Residual Value}}{\text{Useful Life (years)}}$$

Example: A machine costs ₹50,000, has a residual value of ₹5,000, and a useful life of 5 years. Calculate annual depreciation.

Cost = 50000
Residual = 5000
Life = 5
Depreciation = (Cost - Residual) / Life
print(Depreciation)  # Output: 9000

Answer: ₹9,000 per year.

2. Reducing Balance Method (RBM)

Higher depreciation in early years (useful for assets that wear out faster initially).

Formula: $$\text{Annual Depreciation}=\text{Book Value at Start of Year}\times \text{Rate (\%/100)}$$

Example: Same machine as above, but with 20% reducing balance rate. Year 1: Book Value = ₹50,000 Depreciation = ₹50,000 × 20% = ₹10,000 Book Value at end = ₹50,000 – ₹10,000 = ₹40,000

Year 2: Depreciation = ₹40,000 × 20% = ₹8,000 Book Value at end = ₹40,000 – ₹8,000 = ₹32,000

3. Units of Production Method

Depreciation depends on actual usage (hours, units produced, etc.).

Formula: $$\text{Depreciation per Unit}=\frac{\text{Cost}-\text{Residual Value}}{\text{Total Estimated Units}}$$ $$\text{Annual Depreciation}=\text{Depreciation per Unit}\times \text{Units Produced This Year}$$

Example: A machine costs ₹20,000, residual value ₹2,000, and can produce 10,000 units in its life. If 2,000 units are produced in Year 1: Depreciation per unit = (₹20,000 – ₹2,000) / 10,000 = ₹1.80 per unit Annual Depreciation = ₹1.80 × 2,000 = ₹3,600

Comparison Table: Depreciation Methods

Accounting for Depreciation

Depreciation is recorded in two ways:

1. Journal Entry for Depreciation

sequenceDiagram
    participant A as Depreciation Expense
    participant B as Accumulated Depreciation
    participant C as Ledger
    A->>B: ₹X (e.g., ₹9,000)
    B->>C: Record in Accumulated Depreciation
    C->>A: Record in Depreciation Expense

Example Entry:

Dr. Depreciation A/c          ₹9,000
    To Accumulated Depreciation A/c   ₹9,000

(For SLM: ₹9,000 per year for 5 years)

2. Balance Sheet Presentation

Assets are shown at book value (Cost – Accumulated Depreciation).

Balance Sheet Extract:

Assets:
- Machine (Cost: ₹50,000)       ₹50,000
  Less: Accumulated Depreciation (₹9,000 × 2) ₹18,000
  Net Book Value                     ₹32,000

Disposal of Depreciated Assets

When an asset is sold or discarded, we calculate:

1. Profit/Loss on Sale = Sale Price – Book Value
2. Update depreciation records.

Example: A machine (Cost: ₹50,000, Accumulated Depreciation: ₹30,000) is sold for ₹18,000. Book Value = ₹50,000 – ₹30,000 = ₹20,000 Profit/Loss = ₹18,000 – ₹20,000 = ₹2,000 (Loss)

Journal Entry:

Dr. Bank A/c                     ₹18,000
    To Machine A/c                ₹20,000
    To Profit & Loss A/c          ₹2,000

(If sold for ₹25,000, it would be a profit of ₹5,000.)

Depreciation vs. Other Concepts

NEB Board-Style Questions (Practice)

Question 1 (Numerical)

A company buys a machine for ₹40,000 with a residual value of ₹4,000 and a useful life of 5 years. Calculate: a) Annual depreciation using SLM. b) Depreciation for Year 2 using 20% RBM.

Answer: a) SLM: (₹40,000 – ₹4,000) / 5 = ₹7,200 per year. b) RBM: Year 1: ₹40,000 × 20% = ₹8,000 Book Value at end Year 1 = ₹40,000 – ₹8,000 = ₹32,000 Year 2: ₹32,000 × 20% = ₹6,400

Question 2 (Journal Entry)

A company has a car (Cost: ₹150,000, Accumulated Depreciation: ₹60,000) sold for ₹95,000. Record the journal entry for disposal.

Answer:

Dr. Bank A/c                     ₹95,000
    To Car A/c                    ₹90,000
    To Profit & Loss A/c          ₹5,000

(Book Value = ₹150,000 – ₹60,000 = ₹90,000; Profit = ₹95,000 – ₹90,000 = ₹5,000)

Question 3 (Conceptual)

Why is depreciation recorded even if an asset is not used?

Answer: Depreciation accounts for wear and tear due to time (e.g., a car parked in a garage still loses value). It ensures the matching principle (expenses are matched with revenue) and provides a true financial picture.

Exam Tip

1. Memorize Formulas:

   • SLM: (Cost – Residual) / Life
   • RBM: Book Value × Rate
   • Units of Production: (Cost – Residual) / Total Units × Actual Units

2. Show Workings: NEB marks steps in calculations. Always write:

   • Cost, Residual, Life/Units.
   • Depreciation per year/unit.

3. Disposal Scenarios: Practice profit/loss on sale calculations. Remember:

   Profit/Loss = Sale Price – Book Value
   

4. Journal Entries: Always debit Bank/Asset Sold and credit Asset Account + Profit/Loss.

5. Common Mistakes to Avoid:

   • Forgetting to subtract residual value in SLM.
   • Using the wrong rate in RBM (e.g., 20% of cost instead of book value).
   • Not updating accumulated depreciation in the balance sheet.

Real-World Example

In a Nepalese textile factory, a loom costs ₹200,000 and is expected to last 10 years with no residual value. Using SLM, the factory records ₹20,000 depreciation annually, reflecting the loom’s gradual wear in financial records.

Summary Flowchart

flowchart TD
    A["Asset Purchased"] --> B["Choose Depreciation Method"]
    B --> C["SLM/RBM/Units of Production"]
    C --> D["Calculate Annual Depreciation"]
    D --> E["Record in Books"]
    E --> F["Update Balance Sheet"]
    F --> G["Disposal?\n(Yes/No)"]
    G -->|"Yes"| H["Calculate Profit/Loss"]
    G -->|"No"| I["Continue Recording"]

Key Takeaway: Depreciation is a systematic process to allocate an asset’s cost over its life and ensure accurate financial reporting.