Depreciation is an important accounting concept that helps businesses allocate the cost of tangible and intangible assets over their useful life. It represents the reduction in the value of an asset due to wear and tear, passage of time, obsolescence, or usage. In financial statements, depreciation ensures that assets are not overvalued and that profits are reported accurately.
The Companies Act, 2013, governs the depreciation methods that companies in India must follow. The Act ensures consistency, transparency, and fairness in financial reporting by providing guidelines on the useful life of assets and calculation methods. This article provides a comprehensive overview of depreciation as per the Companies Act, 2013, including its definition, methods, provisions under Schedule II, and its importance in financial statements.
Meaning and Purpose of Depreciation
What is Depreciation?
Depreciation is the systematic allocation of the cost of an asset over its useful life. It ensures that businesses spread the cost of assets across multiple years rather than recording the full cost in one year.
Why is Depreciation Important?
- Accurate Profit Calculation: Depreciation is an expense that reduces the taxable income of a company.
- True and Fair Financial Position: It ensures that assets are reported at their correct value.
- Compliance with Accounting Standards: Businesses must follow depreciation rules to comply with legal and regulatory frameworks.
- Future Planning: Depreciation helps businesses plan for asset replacement and financial forecasting.
Depreciation under Companies Act, 2013
Key Provisions
The Companies Act, 2013, introduced major changes in depreciation accounting. The most significant change was the shift from the rate-based depreciation system under the Companies Act, 1956, to the useful life-based system under the 2013 Act.
Under the new provisions:
- Depreciation is calculated based on the useful life of assets, as prescribed in Schedule II of the Act.
- Companies can adopt a different useful life for assets if justified with a technical assessment.
- Component accounting is mandatory, meaning that significant parts of an asset that have different useful lives should be depreciated separately.
Methods of Depreciation under Companies Act, 2013
The Companies Act, 2013, allows businesses to choose between two depreciation methods:
1. Straight Line Method (SLM)
- Under this method, depreciation is charged equally every year over the useful life of the asset.
- The formula for annual depreciation: Depreciation per year=Cost of Asset−Residual ValueUseful Life of Asset\text{Depreciation per year} = \frac{\text{Cost of Asset} – \text{Residual Value}}{\text{Useful Life of Asset}}
- It is simpler to calculate and is commonly used for intangible assets like patents and copyrights.
Example:
A company purchases a machine for ₹5,00,000 with a useful life of 10 years and a residual value of ₹50,000.
Depreciation per year=5,00,000−50,00010=₹45,000 per year\text{Depreciation per year} = \frac{5,00,000 – 50,000}{10} = ₹45,000 \text{ per year}
2. Written Down Value Method (WDV)
- Under WDV, depreciation is charged on the book value of the asset, resulting in higher depreciation in the earlier years and lower depreciation later.
- The formula for depreciation: Depreciation=Book Value at Beginning of Year×Depreciation Rate\text{Depreciation} = \text{Book Value at Beginning of Year} \times \text{Depreciation Rate}
- This method is commonly used for machinery and equipment as their value declines more rapidly in the initial years.
Example:
A company purchases equipment for ₹5,00,000, and the depreciation rate is 20%.
- Year 1: ₹5,00,000 × 20% = ₹1,00,000 (Depreciation) → Remaining Value = ₹4,00,000
- Year 2: ₹4,00,000 × 20% = ₹80,000 → Remaining Value = ₹3,20,000
- Year 3: ₹3,20,000 × 20% = ₹64,000 → Remaining Value = ₹2,56,000
Schedule II – Useful Life of Assets
Schedule II of the Companies Act, 2013, provides a detailed list of asset categories along with their prescribed useful lives. Some examples include:
- Buildings: 30-60 years (depending on the type of construction)
- Furniture & Fixtures: 10 years
- Computers: 3-6 years
- Plant & Machinery: 15 years
- Vehicles: 8-10 years
Component Accounting
Schedule II requires companies to separately depreciate major components of an asset that have different useful lives. For example, in an aircraft, the engine and the body have different lifespans and should be depreciated separately.
Differences Between Companies Act, 2013 and Income Tax Act, 1961
While depreciation is allowed under both Acts, the method of calculation differs:
| Criteria | Companies Act, 2013 | Income Tax Act, 1961 |
|---|---|---|
| Method Allowed | SLM & WDV | Only WDV (except for power sector companies) |
| Useful Life | As per Schedule II | Depreciation rates specified in Income Tax Rules |
| Component Accounting | Mandatory | Not required |
| Depreciation Rate | Based on estimated useful life | Fixed rates for asset categories |
This means that financial statements prepared under the Companies Act may show different depreciation amounts than what is used for tax calculations.
Impact of Depreciation on Financial Statements
1. Profit and Loss Statement (P&L Statement)
- Depreciation is treated as an expense, reducing the company’s net profit.
- Higher depreciation in earlier years (under WDV) results in lower profits in the initial years.
2. Balance Sheet
- Depreciation reduces the carrying value of assets over time.
- Assets are shown at historical cost minus accumulated depreciation.
3. Cash Flow Statement
- Depreciation is a non-cash expense, meaning it does not affect the company’s actual cash flow.
- It is added back in the operating cash flow section of the cash flow statement.
Real-Life Example of Depreciation
A manufacturing company purchases a machine for ₹50,00,000 with a useful life of 10 years.
Using SLM:
Annual Depreciation=50,00,00010=₹5,00,000\text{Annual Depreciation} = \frac{50,00,000}{10} = ₹5,00,000
Each year, ₹5,00,000 is charged as depreciation until the machine is fully depreciated.
Using WDV (Rate: 15%):
- Year 1: ₹50,00,000 × 15% = ₹7,50,000 → Remaining Value = ₹42,50,000
- Year 2: ₹42,50,000 × 15% = ₹6,37,500 → Remaining Value = ₹36,12,500
This shows how the two methods affect the financial statements differently.
Conclusion
Depreciation plays a crucial role in financial accounting, ensuring that companies present a true and fair value of their assets. Under the Companies Act, 2013, depreciation is based on useful life rather than fixed rates, providing flexibility while maintaining consistency.
By following the prescribed methods and Schedule II guidelines, companies can ensure accurate financial reporting, compliance with laws, and efficient financial planning. Understanding depreciation is essential for businesses, investors, accountants, and auditors as it impacts profitability, taxation, and asset management.