What is Depreciation and its Types?

Depreciation and Its Types

The reduction in value of a tangible fixed asset due to normal usage, wear and tear, new technology or unfavorable market conditions is called Depreciation. Assets such as plants and machinery, buildings, vehicles, etc. which are expected to last more than one year, but not for infinity, are subject to this reduction. It is allocation of the cost of a fixed asset in each accounting period during its expected time of use.

 

Journal entry for depreciation (Assuming no provision is maintained)

 Depreciation A/C  Debit
   To Asset A/C  Credit

 

Types of Depreciation

  • Straight Line Method
  • Diminishing Value Method
  • Annuity method
  • Machine hour rate method
  • Revaluation method
  • Sum-of-the-years’ digit method

 

Straight Line Method

Also known as Original cost method, Fixed installment method and Fixed percentage method.

The simplest, most used and popular method of charging depreciation is straight line method. An equal amount is allocated for each accounting period. The rate of depreciation is the reciprocal of the estimated useful life of an asset, so, for example, the useful life of an asset is 5 years, the depreciation charged will be 1/5 = 20%. 

 

According to Straight Line Method,

Depreciation Amt = (Cost of asset − Salvage Value) / Useful life of asset in years

 

Example – Straight Line Method

Asset cost = 1,000,000

Depreciation Rate = 20%

1st year = 20/100*1,000,000

=>2,00,000

2nd year = 20/100*1,00,000

=>2,00,000

 

Advantages of  Straight Line Method are:

  1. Simple and easy to understand.
  2. The book value of an asset can be reduced to Zero.
  3. A fair evaluation of an asset each year in the balance sheet.

 

Diminishing Value Method

Also known as Written down value method, Reducing installment method and Fixed percentage on diminishing balance.

According to the diminishing value method, depreciation is charged on reducing balance on a fixed rate. Depreciation, in this case, is charged over the useful life of an asset over its written down value. The percentage, at which depreciation is charged, remains fixed, however, the amount of depreciation goes on diminishing year after year.

 

According to the Diminishing Value Method,

Formula Diminishing Balance Method Depreciation

 

D = Depreciation %

n = Useful life of asset in years

r = residual value of asset

c = Cost of asset

 

Example – Diminishing Value Method

Asset cost = 1,000,000

Depreciation rate = 20% (DVM)

1st year = 20/100*1,000,000

=>2,00,000

2nd year = 20/100*(1,000,000-2,00,000)

=>1,60,000

 

Advantages of Diminishing Value Method are:

  1. More practical and easy to apply.
  2. Decreasing charge for depreciation cancels out increasing charges for repairs.
  3. This method is applicable for income tax purposes.

 

>Read Accumulated Depreciation