What is Depreciation? Understanding Asset Value Decline

Ever wondered why your brand-new car loses 20% of its value the moment you drive it off the showroom? Or why a company's balance sheet shows declining asset values year after year? That's depreciation at work. Understanding depreciation is crucial not just for businesses but for personal financial decisions too.

What is Depreciation?

Depreciation is the gradual decrease in the value of an asset over time. It happens because assets like machinery, vehicles, buildings, and equipment lose value as they get older, are used, or become technologically obsolete.

In accounting terms, depreciation is the process of allocating the cost of a tangible fixed asset over its useful life. Instead of recording the entire cost as an expense when purchased, the cost is spread across the years the asset is expected to be useful.

Why Does Depreciation Matter?

1. For Businesses

• Tax Benefits - Depreciation is a deductible expense that reduces taxable income
• Accurate Financial Statements - Shows true value of assets over time
• Asset Management - Helps plan for replacement and upgrades
• Matching Principle - Expenses recorded in same period as related income

2. For Investors

• Understanding Company Health - High depreciation may indicate aging assets
• Cash Flow Analysis - Depreciation is a non-cash expense
• Evaluating Capital Expenditure - How efficiently companies use assets

3. For Individuals

• Vehicle Purchases - Cars depreciate 15-20% annually
• Real Estate - Buildings depreciate (land doesn't)
• Insurance Claims - Depreciation affects claim payouts

Types of Assets That Depreciate

Tangible Assets (Physical)

• Buildings and factories
• Machinery and equipment
• Vehicles (cars, trucks, forklifts)
• Furniture and fixtures
• Computers and electronics

Intangible Assets (Amortization)

• Patents and copyrights
• Trademarks and brand value
• Software licenses
• Goodwill (in certain cases)

Note: Land does not depreciate as it has unlimited useful life. In fact, land typically appreciates over time.

Methods of Calculating Depreciation

1. Straight-Line Method (SLM)

The simplest and most commonly used method. Equal depreciation is charged every year.

Formula:

Annual Depreciation = (Cost - Salvage Value) ÷ Useful Life

Example:
Machine cost: Rs 1,00,000
Salvage value: Rs 10,000
Useful life: 10 years
Annual depreciation = (1,00,000 - 10,000) ÷ 10 = Rs 9,000/year

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

Depreciation is calculated on the reducing balance each year. Higher depreciation in early years, lower in later years. This method is mandated by Indian Income Tax Act.

Formula:

Depreciation = Book Value at Beginning of Year × Depreciation Rate

Example:
Asset cost: Rs 1,00,000
Depreciation rate: 15%
Year 1: Rs 1,00,000 × 15% = Rs 15,000
Year 2: Rs 85,000 × 15% = Rs 12,750
Year 3: Rs 72,250 × 15% = Rs 10,838

3. Units of Production Method

Depreciation based on actual usage or output. Useful for machinery where wear depends on use, not time.

Formula:

Depreciation = (Cost - Salvage Value) × (Actual Production ÷ Total Expected Production)

4. Sum-of-Years Digits Method

Accelerated depreciation that front-loads expenses. Uses a fraction based on remaining useful life.

Depreciation Under Indian Income Tax Act

Under Section 32 of the Income Tax Act, 1961:

• Depreciation is calculated using the Written Down Value (WDV) method
• Rates are specified for different asset classes
• If asset is used for less than 180 days in the year of acquisition, only 50% depreciation is allowed

Key Depreciation Rates (Income Tax Act)

Depreciation in Real Life: Car Example

Understanding car depreciation helps you make smarter buying decisions:

This is why buying a 2-3 year old used car often makes financial sense - someone else has already absorbed the steepest depreciation.

Depreciation vs Appreciation

While most assets depreciate, some appreciate (increase in value):

• Land - Generally appreciates over time
• Gold - Tends to appreciate long-term
• Equity investments - Can appreciate over time
• Collectibles - Art, antiques, rare items may appreciate

Invest in Appreciating Assets

While your car and gadgets depreciate, your mutual fund investments can appreciate over time. At DhanLAP, we help you maximize the value of your appreciating assets through Loan Against Mutual Funds (LAMF).

Instead of selling depreciating assets or taking high-interest personal loans, you can:

• Leverage your investments - Get liquidity without selling
• Keep earning returns - Mutual funds continue growing while pledged
• Lower interest rates - Compared to personal loans
• Quick access - Often same-day disbursement

Final Thoughts

Depreciation is a fundamental concept that affects everything from your car's resale value to company profits and tax calculations. Understanding it helps you make smarter financial decisions - whether you're buying a vehicle, investing in a business, or planning your taxes.

The key takeaway: Focus on building assets that appreciate (stocks, mutual funds, real estate land value) rather than accumulating depreciating assets. Your wealth grows when your assets work for you, not against you.