Depreciation is a measure of loss of value of a depreciable asset arising from use, the passage of time or obsolescence either through technological or market changes. Depreciation is charged in a fair proportion of the depreciable amount in every accounting period during the expected useful life of the asset. As everything loses value over time, we are able to treat depreciation as an expense because it is beneficial to the company, which owns the depreciable assets. Depreciation charged on the depreciable assets can be recorded as an expense in the Profit & Loss A/c.
The depreciation charged as an expense in the Profit & Loss A/c helps compensate the company for the value lost on the depreciable assets. Depreciable assets are those assets that are used for the purpose of business which can be depreciated. That is, the value of the asset is considered as a business expense over the useful life of the asset. A company can depreciate most of the tangible assets like Building, Machinery, Vehicles, Furniture and Fixtures, Computers and Equipment and intangible assets like Patents, Copyrights and Computer Software.
Depreciation is often a difficult concept in accounts as it does not represent real cash flow. The purpose of depreciation is to charge to Profit & Loss A/c, a portion of an asset that relates to the revenue generated by that asset, which is called the matching principle, where revenues and expenses both appear in the Profit & Loss A/c in the same reporting period, which gives the best view of how well a company has performed in a given reporting period.
The difficulty with this matching concept is that there is an insubstantial connection between the generation of revenue and a specific asset. All the assets of a company should be treated as a single system that generates a profit; thus, there is no way to link a specific fixed asset to specific revenue. The business concern will stop depreciating the business asset when:
If we were not to charge depreciation at all, then we would have to write off all the business assets as an expense, as soon as we purchase them. This would result in large losses in the months when the transaction occurs, followed by unusually high profitability in those periods when the corresponding amount of revenue is recognized, with no offsetting expense. Thus, a company that does not use depreciation will have extremely variable financial results.
Depreciation is calculated annually based on the methods specified in the statute. Companies Act prescribes two methods for calculating depreciation:
As per the Income Tax Act, 1961, depreciation is to be calculated as per Block of Assets criteria by following WDV Method The Indian Companies Act, 2013 specifies useful life of the various class of assets in Schedule II, as a basis to determine the rate of depreciation under SLM, WDV or Unit of Production (UOP) method. The method of depreciation selected affects the profit as well as the carrying value of assets of a Company.
Depreciation is claimed by the company for two purposes:
In accountancy, depreciation refers to two aspects – a decrease in the value of the assets and allocation of the cost of assets to the useful life of the assets. Under Companies Act, 2013, The depreciation is calculated on the basis of the useful life of assets and not on the basis of the rate of depreciation. Reference Chart of Useful Lives – http://www.mca.gov.in/SearchableActs/Schedule2.htm
In taxation, depreciation refers to the reduction in net taxable income to reduce the amount of tax payable by the company. Under Income Tax Act 1961, depreciation on assets is allowed as an expense to the company while arriving at income under the head of Income from business and profession, from the year in which asset is put to use for the first time and is calculated on the basis of the block of assets at the rates specified in the income tax act in that regard.
As the depreciation methods differ for taxation and for accounting purpose. The amount of depreciation as per Income Tax Act and as per the Companies Act also differs. This will give rise to a timing difference, which requires to be quantified in the financial statements in the form of deferred tax liability / deferred tax asset.