Why is calculating depreciation essential for businesses?
Here are the main reasons why depreciation is important in modern accounting:
- Matching principle: This means expenses should be recorded in the same period as the income they help to earn.
- Clearer financial picture: Depreciation shows a more accurate view of a company’s financial health and performance.
- Tax benefits: Depreciation is an expense that reduces taxable income, helping the company pay less tax.
- Asset management: It helps businesses keep track of the value of their assets and plan when to replace them in the future.
How to calculate depreciation?
When setting up a depreciation plan for an asset, there are three main things to consider:
- Depreciable base: This is the total cost of the asset minus its estimated resale value (called salvage value) at the end of its use. The total cost includes the purchase price and any extra costs to get the asset ready for use.
- Useful life: This is the estimated time the asset will be used before it becomes outdated or too worn out. It doesn’t always match the actual physical life of the asset.
- Best method: This is the way chosen to calculate depreciation. It should be logical and suit the type of asset. Some methods reduce value based on time, while others depend on how much the asset is used. Many businesses choose a simple method to keep things easy and reduce paperwork.
Types of depreciation with calculation and examples
Depreciation methods in India:
1. Straight-line depreciation:
- Simplest method.
- Deducts the same amount of depreciation annually from the asset's original cost.
- Formula: Depreciation = (Original Cost - Salvage Value) / Useful Life.
- Example: A machine costing Rs. 100,000 with a 5-year useful life depreciates by Rs. 20,000 annually.
2. Reducing balance method (Written-down value method):
- Applies a fixed percentage of depreciation to the remaining balance of the asset each year.
- Formula: Depreciation = Depreciation Rate × Book Value at the Beginning of the Year.
- Example: If the depreciation rate is 20% and the machine's initial value is Rs. 100,000, the depreciation in the first year is Rs. 20,000.
3. Sum-of-Years' digits method:
- Considers the total useful life of the asset.
- Calculates depreciation based on a fraction of the asset's original cost each year.
- Formula: Depreciation = (Remaining Useful Life / Sum of Years' Digits) × (Original Cost - Salvage Value).
- Example: For a machine with a 5-year useful life, the first-year depreciation is 5/15 of the original cost.
How businesses use depreciation for tax savings
Companies in India use depreciation to lower their tax payments under the Income Tax Act. When a business buys expensive equipment or assets, it cannot claim the full cost as an expense in one year. Instead, it deducts parts of the cost over several years, matching the time the asset is expected to be used.
The Income Tax Act allows businesses to claim depreciation on assets they own and use for their business or to earn income. Sometimes, there are provisions that allow quicker deductions on certain types of assets, helping businesses save on taxes earlier.
According to Indian tax rules, an asset must meet these conditions to be depreciated:
- It should be owned by the business (not leased).
- It must be used for business or income-generating purposes.
- It should have a useful life that can be reasonably estimated.
- It is expected to last more than one year.
- It should not be an excluded item, such as intangible assets (which are usually amortized) or assets used for building capital improvements.
Depreciation under the Income Tax Act, 1961 (India)
Depreciation is covered under section 32 of the Income Tax Act, 1961. It refers to the reduction in the value of an asset over time due to use, age, or wear and tear. Depreciation is claimed only for accounting and tax purposes – it helps reduce the amount of taxable income.
The law allows businesses to claim depreciation on both tangible assets (like buildings, factories, and machines) and intangible assets (like patents, trademarks, copyrights, franchises, or other business rights). For capital assets, the depreciation amount can be deducted from their original cost.
How depreciation impacts financial statements
Depreciation affects all three main financial statements of a business:
- Income statement: Depreciation is shown as an expense, which lowers the company’s profit and also reduces the taxable income.
- Balance sheet: It reduces the value of fixed assets over time through an account called "accumulated depreciation," which shows how much value has been written off.
- Cash flow statement: Since depreciation does not involve actual cash outflow, it is added back to the net profit under operating activities.
How Does Depreciation Differ from Amortization?
Aspect
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Depreciation
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Amortization
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Type of Assets
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Tangible assets like machinery, equipment, buildings
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Intangible assets like patents, copyrights, goodwill
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Purpose
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Reflects the decrease in value due to wear and tear, obsolescence, etc.
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Spreads out the cost of intangible assets over their useful life
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Calculation Method
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Methods like straight-line depreciation or reducing balance method
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Typically calculated using the straight-line method
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Common Industries
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Manufacturing, construction, real estate
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Technology, pharmaceuticals, finance
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Example
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Depreciating the value of machinery over its useful life
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Amortizing the cost of a patent over its legal life
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This table provides a clear comparison between depreciation and amortization, highlighting their differences in terms of assets, purpose, calculation methods, industries, and examples.
How does depreciation affect your business loan eligibility?
Depreciation can affect your chances of getting a business loan in both good and bad ways.
On the positive side, lenders often see depreciation as helpful because it is a non-cash expense — meaning no actual money is spent. When depreciation is added back to your net profit, your cash flow (EBITDA) looks stronger, which shows that your business is better able to repay the loan.
On the negative side, depreciation reduces the value of your assets in the balance sheet. If you plan to use these assets as security (collateral) for a secured business loan, the loan amount will be based on their lower, depreciated value.
Helpful resources and tips for business loan borrowers