Depreciation: Definition, Types, Methods, Tax Benefits, and How to Calculate It

Depreciation explained with methods, examples, tax benefits, financial impact, and differences from amortization and tax depreciation.
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14 January 2026

Depreciation is an important accounting idea that helps show the true financial position of a company and how it manages its long-term assets. This article explains what depreciation is, why it matters in business accounting, and the different ways to calculate it. It also covers how depreciation affects taxes and financial reports. You will learn how businesses use depreciation to follow accounting rules, reduce tax payments, and improve chances of getting loans. The article also explains depreciation under the Income Tax Act, 1961 (India), how it is different from amortization, and how managing depreciation well helps in planning assets and making better financial decisions.

What is depreciation?

Depreciation is an accounting method used to allocate the cost of a physical asset—such as machinery, vehicles, or buildings—over the period it is expected to be used. It reflects the gradual loss in value caused by regular use, wear and tear, or becoming outdated. Rather than recording the full cost in one year, businesses spread the expense over several years, which gives a more accurate picture of profits and helps lower taxable income.

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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.

Advantages of Depreciaton

  • Tax Savings: Depreciation is a non-cash, tax-deductible expense. By recording it, businesses reduce their taxable income and lower their overall tax burden.
  • Accurate Financial Reporting: Depreciation follows the matching principle by spreading the cost of an asset over the income it generates, giving a more realistic picture of profitability than charging the full cost upfront.
  • Planning for Asset Replacement: Tracking depreciation helps businesses estimate how long an asset will last, making it easier to plan budgets and set aside funds for future replacements.
  • Correct Asset Valuation: It keeps the balance sheet accurate by showing the true book value of assets as they age or become obsolete.
  • Better Cash Flow Management: Tax savings from depreciation release cash that can be reinvested in business growth, staffing, or marketing activities.
  • Stronger Loan Applications: Well-maintained depreciation records reflect financial discipline and transparency, improving a business’s credibility when applying for loans.

Depreciation practical examples

  • Business Vehicle: If a company buys a car for Rs. 10 lakh, it can claim depreciation of 15%, which comes to Rs. 1.5 lakh in the first year. However, if the vehicle is used for less than 180 days in the year of purchase, only half the rate (7.5%) can be claimed for tax purposes.
  • Electronics: A laptop bought for an employee at Rs. 60,000 qualifies for a higher depreciation rate of 40%, allowing a first-year deduction of Rs. 24,000.
  • Office Fixtures: Items such as furniture, fans, and electrical fittings are depreciated at a rate of 10%.
  • Car Insurance (IDV): For personal vehicles, the Insured Declared Value (IDV) is calculated using standard depreciation rates set by IRDAI. For instance, a car that is 3 to 4 years old usually has 40% depreciation applied to its original ex-showroom price.

Difference between Depreciation and Amortization

Aspect

Depreciation

Amortization

Type of Assets

Tangible assets like machinery, equipment, buildings

Intangible assets like patents, copyrights, goodwill

Purpose

Reflects the decrease in value due to wear and tear, obsolescence, etc.

Spreads out the cost of intangible assets over their useful life

Calculation Method

Methods like straight-line depreciation or reducing balance method

Typically calculated using the straight-line method

Common Industries

Manufacturing, construction, real estate

Technology, pharmaceuticals, finance

Example

Depreciating the value of machinery over its useful life

Amortizing the cost of a patent over its legal life


This table provides a clear comparison between depreciation and amortization, highlighting their differences in terms of assets, purpose, calculation methods, industries, and examples.

Difference between accounting depreciation and tax depreciation

Aspect

Accounting Depreciation (Companies Act, 2013)

Tax Depreciation (Income Tax Act, 1961)

Governing Law

Regulated by the Companies Act, 2013 (Schedule II) and applicable accounting standards (Ind AS / AS 6).

Governed by the Income Tax Act, 1961, mainly Section 32 and related rules.

Main Objective

To show a true and fair view of financial performance by spreading the cost of an asset over its useful life.

To calculate taxable income correctly and determine allowable depreciation for tax purposes.

Basis of Calculation

Calculated on the estimated useful life of each individual asset and its residual value.

Calculated using the “block of assets” concept with fixed depreciation rates prescribed under tax laws.

Methods Allowed

Straight-Line Method (SLM), Written Down Value (WDV), or Unit of Production method.

Mostly the Written Down Value (WDV) method is used, except for certain cases like power generation units where SLM is allowed.

First-Year Usage Rule

Depreciation is charged proportionately based on the actual number of days the asset is used.

Full depreciation is allowed if the asset is used for more than 180 days; otherwise, only 50% of the normal rate is allowed.

Resulting Difference

Differences in depreciation create timing differences, recorded as deferred tax assets or liabilities in the accounts.

Tax returns follow Income Tax Act rules, with adjustments made to reconcile accounting profit and taxable income.


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.

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Frequently asked questions

What do you mean by depreciation?

Depreciation is the gradual decrease in the value of assets over time. It happens because assets, like machinery or buildings, lose value as they get older or are used. Businesses account for depreciation to show how much an asset's value has decreased on their financial statements.

What is depreciation formula?

The depreciation formula calculates the decrease in value of a tangible asset over time. It's often computed by subtracting the salvage value of the asset from its initial cost, then dividing the result by its useful life in years.

How to file depreciation?

To file depreciation, gather information on the asset's cost, its expected useful life, and the chosen depreciation method. Then, calculate the depreciation expense using the chosen method, and record it in the company's financial statements, typically in the income statement or as an adjustment to the asset's carrying value.

What is a depreciation example?

An example of depreciation would be:

A company purchases a delivery van for Rs. 500,000. Over its 5-year useful life, the van Rs. depreciates by 100,000 annually using the straight-line method, reflecting wear and tear. After 5 years, the van's value depreciates to Rs. 0.

What is the depreciation rate?

The depreciation rate represents the percentage of an asset's cost that is expensed each year. It varies based on the chosen depreciation method and the asset's useful life, influencing the amount deducted annually to reflect the asset's decreasing value.

What are the three general types of depreciation?

The three general types include straight-line depreciation, which evenly deducts depreciation over the asset's useful life; declining balance depreciation, where depreciation decreases over time; and sum-of-years' digits method, which applies a varying rate based on the asset's total useful life.

Why do we calculate depreciation?

Depreciation is calculated to allocate the cost of a fixed asset over its useful life. This process reflects the gradual reduction in the asset’s value due to wear and tear, obsolescence, or usage. By calculating depreciation, businesses ensure that their financial statements accurately represent the true value of their assets. It also helps in matching the cost of an asset with the revenue it generates, thereby providing a realistic view of profitability. Depreciation is crucial for tax purposes and maintaining accurate financial records.

Can depreciation be negative?

Depreciation cannot be negative. Depreciation is the allocation of an asset’s cost over its useful life, which results in a reduction of its book value over time. The concept of negative depreciation does not exist, as depreciation represents a loss in value. However, certain situations, such as revaluing an asset upwards, could lead to an increase in the asset’s value, but this would not be termed negative depreciation. Depreciation always reflects a decrease in value, not an increase.

Is depreciation a liability or not?

Depreciation is neither an asset nor a liability. It is an expense that appears on the income statement, representing the reduction in the value of fixed assets. Accumulated depreciation, on the other hand, is a contra asset account that reduces the asset's value on the balance sheet. It reflects the total amount of depreciation charged against an asset since its purchase, but it is not a liability. It helps in providing a more accurate picture of the asset’s net book value.

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