It represents the reduction in market value of an asset due to age, wear and tear and obsolescence. The physical deterioration of the asset occurs due to wear and tear with passage of time. Obsolescence occurs to due to availability of new technology or new product in the market that is superior to the old one and the new one replaces the old even though the old one is still in working condition. The examples of tangible assets for which the depreciation analysis is carried out are construction equipment, buildings, machinery, vehicles, etc. Depreciation amount for an asset is usually calculated on yearly basis. Depreciation is considered as expenditure in the cash flow of the asset, although there is no physical cash outflow. Depreciation affects the income tax to be paid by an individual or a firm as it is considered as an allowable deduction in calculating the taxable income. Generally the income tax is paid on taxable income which is equal to gross income less the allowable deductions (expenditures). Depreciation reduces the taxable income and hence results in lowering the income tax to be paid.
Before discussing about different methods of depreciation, it is necessary to know the common terms used in depreciation analysis. These terms are initial cost, salvage value, book value and useful life. Initial cost is the total cost of acquiring the asset. Salvage value represents estimated market value of the asset at the end of its useful life. It is the expected cash inflow that the owner of the asset will receive by disposing it at the end of useful life. Book value is the value of asset recorded on the accounting books of the firm at a given time period. It is generally calculated at the end of each year. Book value at the end of a given year equals the initial cost less the total depreciation amount till that year. Useful life represents the expected number of years the asset is useful in terms of generating revenue. The asset may still be in working condition after the useful life but it may not be economical. Useful life is also known as depreciable life. The asset is depreciated over its useful life.
The commonly used depreciation methods are straight-line depreciation method, declining balance method, sum-of-years-digits method and sinking fund method.
Straight-line (SL) depreciation method:-
It is the simplest method of depreciation. In this method it is assumed that the book value of an asset will decrease by same amount every year over the useful life till its salvage value is reached. In other words the book value of the asset decreases at a linear rate with the time period.
The expression for annual depreciation in a given year ‘ m ' is presented as follows;
 |
(3.1) |
Where
In equation (3.1), 
is the constant annual depreciation rate which is denoted by the term ‘dm'.
Since the depreciation amount is same every year, D1 = D2 = D3 = D4 = ……… = Dm
The book value at the end of 1st year is equal to initial cost less the depreciation in the 1st year and is given by;
BV1 = P − Dm |
(3.2) |