Depreciation is an important item on the profit and loss account, its nature is often not properly understood by non-finance managers.
This article clarifies what deprecation is, explains the manner in which the depreciation schedule is prepared, presents information on the methods and rates of depreciation under the Companies Act and the Income Tax Act, and dispels some of the myths surrounding depreciation.
Nature of Depreciation
A fixed asset is used over a number accounting periods. So it is necessary to allocate its costs to various accounting periods that benefit from its use. Such an allocation is called depreciation. Accountants normally allocate the cost of an asset over its useful life using a well-defined procedure.
Three steps are involved in calculating the depreciation schedule.
1. Determine the depreciable base.
2. Estimate the useful life of the asset
3. Choose the depreciation method
Depreciable Base: The depreciable base is the cost of the asset less its residual value.
The cost of the asset is equal to:
List price less discount
Insurance, freight and handling
Interest during the construction period
The residual value (or salvage value) is the amount expected from the disposal of the asset after its useful life. Since it may not be much or difficult to estimate, it may be put at 5 per cent or so of the original cost or even completely ignored.
Useful Life: The useful life of an asset is the period over which it is expected to be used. Often it is less than the physical life of the asset because of factors such as technological obsolescence, fall in demand and legal restrictions. Estimating the useful life is largely a matter of managerial judgment.
Depreciation method: There are several methods of depreciation. The two most commonly used depreciation methods in India are the straight line method and the written down value method.
Under the straight line method the depreciable amount of the asset is allocated equally over the useful life of the asset. To illustrate, assume that a car costs Rs 500,000 and is expected to fetch a salvage of Rs 80,000 after a useful life of 7 years. The annual depreciation charge is:
Cost – Salvage value / Useful Life
= Rs 500,000 – Rs 80,000/6 = Rs 70,000
Under the written down value method, the depreciation charge for an accounting period is equal to a fixed percentage of the book value at the beginning of the period. To illustrate, assume that the cost of an asset is Rs 100,000 and the depreciation rate applicable to it under the written down method is 40 per cent. The depreciation schedule for the asset will be as follows.
Year Original Depreciation Accumulated Book value
Cost depreciation at year end
1 100,000 40,000 40,000 60,000
2 100,000 24,000 64,000 36,000
3 100,000 14,400 78,400 21,600
4 100,000 8,640 87,040 12,960
5 100,000 5,184 92,224 7,776
Depreciation for company Law and Income Tax Purposes
Unlike most other countries the methods and rates for depreciation are prescribed by law India.
Depreciation under the Companies Act; The Companies Act requires that a company that tends to pay dividend must provide depreciation in accordance with Schedule XIV of the Act. This schedule gives the rates under the straight line method and the written down value method for various classes of assets. For assets used in multiple shifts, extra depreciation has to be provided. The key rates presently are as follows:
Straight line method Writeen Down Value
Building (other than 1.63% 5.00%
Factory buildings 3.34% 10.00%
Temporary Structure 100.00% 100.00%
Furniture & Fittings 6.33% 18.10%
One shift Three shifts One shift Three shifts
Plant & Machinery 4.75% 10.34% 13.91% 27.82%
Note that the above rates are the legal minimum rates for determining divisible profit. The purpose of the Companies Act is to protect the creditors. It tries it ensure that companies do not overstate profits to pay large dividends to the detriment of creditors.
Depreciation for income Tax Purposes: For income tax purposes, tax payers have no choice but to follow the written down value method. The rates permitted for various assets presently are as follows:
Plant and machinery: 25%
Vehicles on hire: 40%
Pollution control equipment: 100%