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Depreciation

General

Asset Depreciation

The systematic reduction in the book value of a tangible asset over its useful life, reflecting wear and tear. Depreciation is a non-cash expense that reduces taxable profit and is added back in EBITDA calculations.

Definition

Depreciation is the systematic allocation of the cost of a tangible fixed asset over its estimated useful life, reflecting the gradual consumption of the asset's economic value through use, wear and tear, or obsolescence.

In accounting, depreciation is recognised as an expense in the income statement, reducing net profit — but it is a non-cash charge (no money leaves the company when depreciation is booked). In tax, depreciation reduces taxable income, providing a tax benefit (tax shield).

Depreciation applies to physical assets with a finite useful life: machinery, vehicles, computers, buildings. It does not apply to land (considered to have indefinite life) or financial assets.

Common depreciation methods:

  • Straight-Line Method (SLM): Equal depreciation each year
  • Written Down Value / Declining Balance (WDV): Higher depreciation in early years, lower later
  • Units of Production: Depreciation based on actual usage

Formula

Straight-Line Depreciation:

Annual Depreciation = (Cost − Salvage Value) / Useful Life (years)

Written Down Value (WDV) Depreciation:

Annual Depreciation = Book Value at Start of Year × Depreciation Rate

WDV at end of year = Previous WDV − Depreciation for the year

Tax Shield from Depreciation = Depreciation Amount × Tax Rate

Worked Example

SLM vs WDV comparison:

Machinery cost: ₹10,00,000. Salvage value: ₹1,00,000. Useful life: 5 years. WDV tax rate: 15%.

Year SLM (₹) WDV Opening (₹) WDV Depreciation (15%) WDV Closing (₹)
1 1,80,000 10,00,000 1,50,000 8,50,000
2 1,80,000 8,50,000 1,27,500 7,22,500
3 1,80,000 7,22,500 1,08,375 6,14,125
4 1,80,000 6,14,125 92,119 5,22,006
5 1,80,000 5,22,006 78,301 4,43,705

SLM gives equal annual depreciation (₹1.8L) — stable expenses. WDV gives higher depreciation in Year 1 (₹1.5L for 15%) and declining thereafter — front-loads the tax benefit.

Key Things to Know

  • Tax shield value: The primary economic benefit of depreciation for businesses is the tax shield. If depreciation is ₹10 lakh and tax rate is 25%, the depreciation saves ₹2.5 lakh in cash taxes this year. Higher depreciation rates (WDV) front-load this benefit — the present value of a front-loaded tax shield exceeds an evenly spread one.
  • Depreciation and free cash flow: Depreciation reduces accounting profit but is added back in cash flow calculations (it's non-cash). A company with ₹50 lakh profit and ₹30 lakh depreciation has ₹80 lakh operating cash flow before working capital changes. This is why EBITDA (which adds back depreciation) is a cash earnings proxy.
  • Goodwill depreciation (pre-2021): Until March 31, 2021, acquired goodwill was depreciable at 25% WDV under the Income Tax Act, providing significant tax benefits on acquisitions. The Finance Act 2021 removed this — acquired goodwill is no longer depreciable for tax purposes. Existing goodwill as of April 1, 2020 is also no longer depreciable — a significant change affecting M&A economics.
  • Block of assets concept (IT Act): Under the Income Tax Act, assets of the same class are grouped into a "block" (e.g., all 15% plant and machinery). Depreciation is computed on the WDV of the entire block, not individual assets. When an asset in the block is sold, the sale proceeds reduce the block WDV. If sale proceeds exceed WDV of the block, the excess is treated as a "short-term capital gain" (terminal depreciation benefit).
  • Personal finance — vehicle depreciation: For salaried individuals, vehicle depreciation isn't directly applicable. But understanding depreciation helps evaluate car purchase vs lease decisions (total cost of ownership over 5 years including depreciation), and explains why resale values drop sharply in the first 2 years of a new car's life — WDV-style real depreciation front-loads the value loss.

Related Calculators

Depreciation Calculator →Calculate asset depreciation using Straight Line (SLM) or Written Down Value (WDV) method. Find annual depreciation, book value, and depreciation rate for your assets.
Profit & Loss Calculator →Calculate profit or loss amount and percentage from cost price and selling price. Includes gross margin for business, trading, and school use.

Related Terms

EBITDAEarnings Before Interest, Taxes, Depreciation and AmortisationAmortisationLoan AmortisationFree Cash FlowFree Cash Flow (FCF)GoodwillIntangible Business Goodwill
Frequently Asked Questions
What is the difference between accounting depreciation and tax depreciation?
Accounting depreciation (as per Companies Act) uses methods like Straight-Line or Written Down Value based on the estimated useful life of the asset. Tax depreciation (as per Income Tax Act) uses Written Down Value (WDV) method with prescribed rates that often differ from accounting useful lives. The difference between accounting and tax depreciation creates a deferred tax liability/asset on the balance sheet.
What assets can be depreciated for income tax purposes?
Under the Income Tax Act, tangible assets used in business (machinery, vehicles, computers, furniture, building) and certain intangible assets (goodwill acquired before April 2021, patents, copyrights, know-how) are eligible for depreciation. Land cannot be depreciated. Personal-use assets (e.g., your personal car) cannot be depreciated for tax.
What is the depreciation rate on vehicles and computers?
Under the Income Tax Act: Motor cars (not for hire): 15% WDV. Computers and peripherals: 40% WDV. Office equipment: 15% WDV. Buildings (permanent structure): 10% WDV. Plant and machinery (general): 15% WDV. New manufacturing machinery: 15% (some eligible for additional depreciation of 20%). The WDV method means the highest depreciation is in Year 1 and reduces each year.
What is additional depreciation under the Income Tax Act?
Section 32(1)(iia) allows an additional 20% depreciation (over and above normal depreciation) in the year of acquisition for new plant and machinery acquired and installed for manufacturing or production purposes. This is not available for second-hand machinery, cars, ships, aircraft, or assets used in service businesses. This benefit encourages investment in new manufacturing capacity.
How does depreciation affect a company's cash flow?
Depreciation is a non-cash expense — it reduces accounting profit but doesn't represent a cash outflow in the current period (the cash was paid when the asset was purchased). This is why operating cash flow is computed by adding depreciation back to net profit. However, the eventual replacement of the asset (capex) is a real cash outflow. Depreciation acts as a tax shield — reducing taxable income and thus reducing actual cash paid as tax.