Depreciation Accounting, Objectives, Methods

Depreciation Accounting refers to the systematic allocation of the cost of a tangible fixed asset over its useful life. It recognizes the gradual reduction in the value of assets like machinery, vehicles, equipment, or buildings due to wear and tear, obsolescence, passage of time, or usage.

It ensures that a business’s income statement reflects the true cost of using assets to generate revenue, thereby presenting an accurate picture of profitability and asset valuation.

Objectives of Depreciation Accounting:

• To Allocate the Cost of Assets Systematically

One of the fundamental objectives of depreciation accounting is to systematically allocate the cost of a fixed asset over its useful life. Assets like machinery or buildings are used over several years, and their cost should be distributed accordingly to reflect the benefit derived each year. This approach avoids charging the entire cost in the year of purchase, ensuring that expenses are matched with revenue, thus offering a more accurate representation of annual financial performance.

• To Comply with the Matching Principle

Depreciation accounting ensures adherence to the matching principle of accounting, where expenses incurred in earning revenue are recorded in the same period as the revenues. By charging depreciation each year, businesses align the expense of using an asset with the revenue it helps generate. This leads to more realistic profit determination and upholds the fundamental principle of accrual accounting, ensuring income statements reflect true operational performance without understating or overstating net income.

• To Show True and Fair Value of Assets

Fixed assets depreciate over time due to wear and tear, usage, or obsolescence. Depreciation accounting adjusts the book value of assets to reflect their actual condition and worth. Without depreciation, the balance sheet would show assets at their original cost, misleading stakeholders. Accurate depreciation ensures that the net book value of assets is neither overstated nor inflated, helping users of financial statements assess the company’s real financial position and asset utilization.

• To Facilitate Provision for Asset Replacement

Depreciation accounting helps businesses accumulate funds gradually for replacing worn-out or obsolete assets. By charging depreciation yearly, businesses are indirectly setting aside a portion of their profits, which can be used when the asset’s useful life ends. This avoids sudden financial pressure of replacing major assets and supports smooth operational continuity. This objective is especially crucial for capital-intensive businesses relying heavily on plant, machinery, and equipment.

• To Ensure Compliance with Legal Requirements

Depreciation is often mandated under accounting standards, tax laws, and corporate regulations. It is essential for businesses to comply with these rules to avoid penalties or legal issues. Depreciation accounting ensures the business adheres to such laws, like the Companies Act or Income Tax Act in India, which prescribe specific depreciation rates and methods. It also helps in determining taxable income accurately, as depreciation is allowed as a deductible expense.

• To Avoid Overstatement of Profits

If depreciation is not accounted for, the company’s profits will be overstated, as the usage cost of assets would be ignored. This may lead to misleading profit reporting and incorrect managerial decisions like excess dividend declarations. Depreciation ensures that annual profits are adjusted for the cost of using long-term assets, offering a more realistic measure of financial performance. This promotes responsible profit distribution and better financial planning for sustainable growth.

• To Support Financial Analysis and Planning

Depreciation accounting provides data that aids in long-term financial planning and analysis. It affects profit margins, return on assets, and fixed asset turnover ratios. Accurate depreciation calculations enable businesses to assess investment efficiency, plan capital expenditures, and manage asset utilization effectively. Analysts and managers use this data to evaluate company performance, forecast future capital needs, and design asset renewal strategies, making depreciation a vital tool in decision-making.

• To Promote Transparency and Credibility

Transparent depreciation accounting increases the credibility of financial statements. Stakeholders such as investors, creditors, and auditors rely on these statements for decision-making. Depreciation demonstrates that the company acknowledges asset usage and decline in value, enhancing trust. It also reflects the firm’s adherence to good accounting practices and standards. By ensuring asset values and profits are not artificially inflated, depreciation promotes honest reporting and strengthens stakeholder confidence in financial disclosures.

Methods of Depreciation:

1. Straight Line Method (SLM)

Concept: A fixed amount is charged as depreciation every year over the asset’s useful life.
Formula:

Depreciation = (Cost of Asset − Residual Value) / Useful Life​

Features:

• Simple to calculate and apply

• Asset value reduces evenly

• Suitable for assets with consistent usage (e.g., furniture)

2. Written Down Value Method (WDV) / Diminishing Balance Method

Concept: A fixed percentage is charged on the book value (not original cost) each year.
Formula:

Depreciation = Opening Book Value × Depreciation Rate

Features:

• Depreciation decreases each year

• More realistic for assets with high early loss in value (e.g., machinery)

• Popular in tax accounting

3. Units of Production Method

Concept: Depreciation is based on actual usage or output rather than time.
Formula:

Depreciation per Unit = (Cost – Residual Value) / Total Estimated Units​

Annual Depreciation = Depreciation per Unit × Units Used in the Year

Features:

• Ideal for manufacturing assets

• Depreciation varies year to year

4. Sum of Years’ Digits Method (SYD)

Concept: An accelerated depreciation method that charges more in early years.
Formula:

Remaining Life ÷ Sum of Years × (Cost – Residual Value)

Where sum of years = 1+2+3+…+n
Features:

• Heavier depreciation in the beginning

• Reflects declining usefulness over time

5. Double Declining Balance Method (DDB)

Concept: Another accelerated method, it doubles the straight-line rate and applies it to book value.
Formula:

Depreciation = 2 × Straight Line Rate × Book Value

Features:

• Fastest depreciation method

• Commonly used in U.S. GAAP

• Best for tech or fast-obsolete assets

6. Annuity Method

Concept: Considers both depreciation and interest on capital invested.
Formula: Based on annuity tables or financial calculators.
Features:

• The depreciation charge is equal each year, but includes interest

• Rarely used in practice due to complexity

7. Depreciation Fund Method (Sinking Fund)

Concept: Depreciation is charged and invested separately each year to accumulate replacement funds.
Features:

• Ensures fund availability to replace assets

• Used for costly, long-term assets like buildings

8. Revaluation Method

Concept: Suitable for small items; the asset is revalued periodically, and the difference is depreciation.
Features:

• Commonly used for tools or livestock

• Used when asset tracking is impractical