This article is written by Sushree Surekha Choudhury from the KIIT School of Law, Bhubaneswar. It provides an insight into the concept of “depreciation” as per the Companies Act, 2013, the legal provisions therein, and the methods to calculate it.
Table of Contents
The term “depreciation” refers to the decrease in the monetary value of any object. Suppose you purchase a car today at the price of Rs. 14 lakhs. Now, after using it for three years, you want to sell it and buy a new one. Would you sell it at the same price that you bought it? No, right? You will obviously sell it at a lower price than its actual cost after calculating the depreciation in the value of your car over the course of three years. It may have incurred certain damages, the model will have become old, the operating system might not be the latest one, it must have run certain kilometres in these three years as opposed to when you bought it, and similar other situations will all contribute to the decrease in value of the asset. Thus, the resale value of the car will always be less than the price at which it was bought. This is exactly what is known as depreciation.
Just as the value of the car depreciates over its useful life, so does the value of every other tangible or intangible asset. In the context of companies, they own assets too, both tangible and intangible. These assets, like the car, depreciate in value with time. Thus, companies adopt procedures to calculate cumulative depreciation, which refers to the depreciation of each asset as determined separately, and all the values are clubbed together to be reduced from the EBITDA (earnings before interest, taxes, depreciation, and amortisation of the company) of all their assets at the end of their useful lives. This is essential to determine the net income of the company accurately. The Companies Act, 2013 provides a regulatory framework to determine the depreciation of assets owned by companies.
In this article, we will learn everything about depreciation as per the Companies Act, 2013, and the methods for determining it.
In simple terms, depreciation refers to the loss in value of an asset due to its usage over a period of time. The loss in value may be caused by various factors, such as a change in the market and market needs, technological advancements, an increase or decrease in the demand and supply ratio, an increase or decrease in the usage of a particular asset, and industry-specific changes, among others. Thus, depreciation is calculated to determine the actual value of assets and also serves other accounting necessities.
Depreciation is used as a “fair proportion value” of the original value, which is deducted from the original value of assets to get an appropriate and accurate value. The calculated loss in value of an asset or depreciation in the value of an asset is a determining factor that is used in accounting. This is used in determining the profit and loss accounts of the company.
Determining depreciation is essential for a company, as it helps them understand the depreciated amount in their profit and loss account and, therefore, compensate for these losses. This depreciation amount is used in determining the value of an asset at the end of its useful life. Depreciation is considered a “business expense” while determining the profit-and-loss statement of the company in a given financial year. Depreciable assets can be tangible, such as buildings, machinery, furniture, vehicles, etc., or intangible, like copyrights, patents, and software of the company. Depreciation is also calculated for movable (like cars, furniture, etc.) and immovable (like land and buildings owned by the company) properties owned by the company.
At the end of any financial year, a company calculates its gross revenue or gross income. Gross income refers to the total revenue or income generated by the business of the company before deducting any expenses incurred or payments made by them. It is determined as the total products sold by the company or the overall services provided by them, in monetary terms.
For calculating gross income, the following assumptions shall be considered :
Assumption Number 1 – The price of each product is the same or identical.
Assumption Number 2 – The price of each service provided to each consumer is identical or the same.
Assumption Number 3 – Each customer is assumed to avail the service or bought the product only once OR if a customer avails the services or buys a product for more than one time (say n times), then such person is not assumed to be one person but rather n customers.
Gross income for a company is calculated as,
Gross income = number of products sold x price of each product, or
Gross income = number of customers served in that year x price of each service.
When gross income is calculated, the next step is to calculate net revenue. Net revenue refers to the actual revenue generated by the company after the payment of expenses, discounts, etc. To calculate net revenue, the following steps are followed:
Therefore, net revenue = gross revenue – returns – discounts.
Returns refer to the products returned to the company, and discounts refer to the discounts given by the company on products or services. Sometimes, allowances are also deducted to calculate net revenue.
Hereafter, gross profit is calculated. Gross profit is calculated by subtracting the cost of goods sold from the net revenue and dividing the result by the net revenue of the company in that financial year.
Meanwhile, the EBITDA of the company is calculated, which ultimately leads to the calculation of depreciation. EBITDA refers to the earnings (net revenue) before interests, taxes, depreciation, and amortisation. Thus, it is the net sales of the company before subtracting any deductions and expenses.
Ultimately, depreciation and amortisation costs are deducted from the EBITDA to determine the EBIT of the company in that financial year. This is when the depreciated amount of the total assets comes into use. Depreciation and amortisation of assets are calculated and deducted from EBITDA.
Finally, interests and taxes are paid by the company, and what remains is the net profit or loss of the company. The remainder is compared with the net income of the company, and if the answer is a positive value, that is the net profit of the company. If this value becomes negative, then the business is burning cash or incurring losses.
Depreciation is the valuation of assets at the end of their useful lives. Attempts are made to make the closest approximation of the actual depreciated value of an asset. As it does not represent real cash flows since the depreciation in value of an asset is subjective and various factors are considered to calculate the closest approximation, the determination of depreciation is tricky. However, it is essential to determine depreciation as it causes a change in the loss and profit margins of the company.
Depreciation is used to charge an amount as revenue that is particular to a particular asset. This charge is made to the profit or loss account and is known as the “matching principle.” The matching principle is a principle in which both revenue and expenses occur in the profit and loss accounts in a specific reporting period. This gives an insight into the overall performance of the company during that period. The matching principle is used in accounting to match and report the revenues and expenses of a company in a given period of time, say, a month, a quarter, or a year. The expenses and revenues of a company are considered to be interrelated, and thus, the matching principle suggests that they should be reported simultaneously.
The matching principle is useful as it helps in reaching an accurate income statement of the company by including all the revenue as well as expense-related activities in the statement of the company. Matching revenues with expenses gives a better perspective on the sales and income of the company as opposed to when the two are disconnected in the statements of the company. The matching principle dictates accountability and reasoning for the numbers that are reflected in the income statement of the company.
Determining depreciation not only helps in knowing the actual value of assets but also helps in stabilising the expenses and revenue of a company. It is because the depreciation is calculated so that the actual current value of an asset can be determined. In the absence of this determination, companies would have to include the purchase value of all the assets as they were on the day they were bought or developed. This will substantially increase the expenses of the company, and the revenue will take a toll. The consequence will be that the financial statements and balance sheet will indicate huge losses for the company in the year or period in which maximum expenses were undertaken. As opposed to this, the period during which no or very little expenditure was made, will reflect fluctuating high profits. Neither of these determinations will be the correct measure of the performance of the company. Additionally, it will result in high fluctuations in the revenue and financial reports of the company.
The Companies Act, 2013 talks about the term “depreciation” through its provisions. Depreciation is calculated annually using any of the prescribed methods. These methods of calculating depreciation are prescribed in the Companies Act, 2013, as well as in the Income Tax Act, 1961.
The Income Tax Act, 1961, prescribes the calculation of depreciation as per the concept of “blocks of assets” using the written down value (WDV) method. The Companies Act, 2013, refers to the calculation of the useful lives of different classes of assets. This calculation of depreciation using the useful life determination or the number of units as a determinant of useful life is known as the “Unit of Production (UOP) Method.” These are specified under Schedule II of the Companies Act, 2013. It prescribes the determination of depreciation using the straight-line method (SLM), written down value (WDV), also known as the unit of production (UOP) method. Therefore, companies can prefer either of the methods for calculating depreciation.
The widely used methods for the calculation of depreciation are:
Let us understand these traditional methods of calculating depreciation in detail:
In the straight-line method, the value of the asset is reduced at regular intervals till it reaches its salvage value. This reduction is carried out uniformly at regular periodic intervals. Salvage value refers to the value of an asset when it reaches the end of its useful life. It is also referred to as “scrap value” or “residual value.” Therefore, this value is used to calculate the depreciation in value of an asset using the straight-line method. Depreciation is calculated using the straight-line method by dividing the cost of an asset, less its salvage value, by the useful life of the asset.
(Cost of Asset – Salvage Value)
Annual depreciation = __________________________
Useful life of the asset
Cost of asset = purchasing price of the asset,
Salvage value = value of the asset at the end of its useful life, and
Useful life of asset = the number of years or the period for which the asset will be used by the company.
Annual depreciation using the straight-line method can also be calculated as:
Annual Depreciation Expense
Straight line depreciation = ___________________________
(Cost of Asset – Salvage Value)
Thus, depreciation using the straight-line method can be calculated using the following steps:
The written-down value method calculates the annual depreciation in the value of assets by determining the depreciation in a company’s fixed assets. Determining the value of fixed assets of a company helps in knowing the actual value of assets. The written-down value method, or “reducing balance” method, is a method in which a predetermined percentage of the value of an asset is included in the balance sheet of the company at the beginning of an accounting year. This method determines the current value of an asset by including an estimated depreciation on the balance sheets at the beginning. Written down value is also known as “book value,” since it is the value that is recorded in the company’s financial statements at the end of an accounting year.
As per the written-down value method,
Depreciation = (cost – salvage value) x rate of depreciation
Rate of depreciation = [1 – (salvage value / initial cost of an asset) ^ 1/n] x 100
Initial cost refers to the cost at which the asset was purchased,
Salvage value refers to the scrap value of the asset or the value of an asset at the end of its useful life, and
“n” refers to the useful life of an asset.
Let us suppose an asset X,
Purchase value of the asset = 12000 INR
Salvage value = 2000 INR
Useful life of the asset = 5 years.
Depreciation rate (WDV) = [1 – (2000/12000) ^ 1/5] x 100 = 30.117%
Taking the same example, let us calculate depreciation using the straight-line method and then compare the two methods for the same asset X.
Thus, depreciation (SLM) = (12000 – 2000) / 5 = 2000 INR.
| Year | Depreciation (Straight line method) | Depreciation (Written down value method) |
| 1 | 2000 INR | 3614.05 INR |
| 2 | 2000 INR | 2525.60 INR |
| 3 | 2000 INR | 1764.95 INR |
| 4 | 2000 INR | 1233.45 INR |
| 5 | 2000 INR | 861.95 INR |
| Total depreciation | 10000 INR | 10000 INR |
Thus, the same results were deduced using two different methods of depreciation. Now that we have understood how to calculate depreciation and the methods used for it, let us understand the concept from the perspective of the Companies Act, 2013.
While the straight-line method and written down value method of calculating depreciation are the most commonly used under Indian laws, let us understand the two other available methods of calculating depreciation:
The double declining balance method helps in determining the depreciation in the value of assets in a quicker manner and at an early stage of their purchase. This method helps reduce the value of assets by deducting the depreciation early, which in turn results in tax benefits through the determination of actual value. It is usually used for determining depreciation for assets that tend to quickly depreciate in value as compared to others, for instance, a car or any other vehicle will depreciate in value faster than furniture or a trademark. It is a convenient method of calculating depreciation and also shows flexibility when an asset is sold by a company before the end of its useful life. Since the double declining balance method calculates depreciation at an early stage, it becomes easier for the company to determine the current value at any point in time when they wish to sell the asset before the completion of its useful life.
As the name suggests, the double declining balance method uses the method of depreciating the value of assets twice at the rate at which they are depreciated under the straight-line method. Thus, the depreciation is calculated as being highest in the first year of calculation and declines in the following years. Therefore, the double declining balance method of calculating depreciation is suitable for assets whose value essentially decreases in the first year of use as compared to the following years, like vehicles, heavy machinery, factory equipment, etc.
In the double declining balance method of calculating depreciation, depreciation is first calculated as per the traditional straight-line method. The value that is arrived at, is doubled. This doubled value is the amount of depreciation for the first year of use of an asset as per the double declining balance method. The remaining amount of depreciation is calculated from the years that follow. The remaining depreciation value is divided by the number of years for which the asset will be used, and this total value is multiplied by two. This process is followed till the final year of use is reached. The double declining balance method is an appropriate way of calculating depreciation as this method is equivalent to the practical scenario of depreciation of assets where the value of assets depreciates the most in the first year and subsequent depreciation is a downward sloping graph.
Depreciation using the double declining balance method can be calculated using the following formula:
Depreciation = (cost of the asset/length of useful life in terms of years) x 2 x book value of the asset at the beginning of the year.
This formula is used for all the consecutive years, and in the final year, the amount of depreciation is determined as the difference between the book value of the asset at the beginning of the year and the final salvage value arrived at till the previous year.
Or, depreciation = 2 x SLDP x BV
SLDP is the straight-line depreciation value, and
BV is the book value of the asset at the beginning of the year.
Yet another method of calculating depreciation is the “sum of the years’ digits” method of calculating depreciation. The sum of the years’ method is referred to as an “accelerated method of calculating depreciation.” As this suggests, the method is used to depreciate the value of an asset at an accelerated rate. The sum of years’ digits method is based on a similar principle as the double declining balance method of calculating depreciation: the value of an asset depreciates faster in the early years of its use as compared to the subsequent years. This is because certain equipment, machinery, etc., are heavily used at the beginning when they are bought.
The essence of each method of calculating depreciation differs in the use of time as a factor. While the resultant depreciation is the same in all cases, the method of reaching it differs. The net income varies for each year in each method of calculating depreciation. In the sum of years’ digits method, the net income remains lower in the initial years as the depreciation is accelerated. But as the years pass by, the depreciation stabilises and lowers, and thus, the net income value increases. The sum of years’ digits method of calculating depreciation helps in determining depreciation using the useful life of assets by aligning with their initial cost. The useful life and the sum of digits of this useful life are used in calculating depreciation.
Using the following steps, depreciation can be calculated using the sum of years’ digits method:
The depreciable amount is determined by subtracting the salvage value of an asset from the cost of acquisition or purchase of the asset.
Thus, depreciable amount = cost of purchase of the asset – salvage value.
Useful years for the asset are determined. The company can adopt an internalised method of determining the useful life of an asset by determining the number of years for which it will use an asset.
The depreciable amount is multiplied by a depreciable factor. This calculation is done for each year of useful life. The depreciable factor is determined as the useful life of an asset divided by the sum of the useful years of the asset. For instance, if the useful life of an asset is determined to be 5 years, the sum of its useful years will be 5 + 4 + 3 + 2 + 1 = 15.
Thus, using the sum of years’ digits method,
Depreciation = (number of useful years/sum of useful years) x depreciable amount.
The Companies Act, 2013, talks about the calculation of depreciation for the calculation of profits and understanding the finances of a company in a given accounting year through its provisions. Let us understand the crucial provisions of the Companies Act which deals with depreciation and its determination.
Provisions for depreciation begin with the requirement of calculating revenues of the company in the given year. The revenue of any company in one accounting year can only be calculated after determining the total revenue made by the company as compared to the revenue spent on various requirements. This difference between the total revenue earned by the company less the expenditure made by them in the given accounting year determines the profit or loss of the company for that particular accounting year. If the annual expenditure deducted from the total revenue earned gives a positive remainder, the company has earned profits. If this resultant value is negative, the company is running with losses.
Section 123 of the Act talks about the declaration and division of dividends. It makes a mandatory provision that the dividends can only be paid after calculating the profits of the company (as per Section 198) for that financial year and only after the depreciation has been deducted. Section 123 is a guiding provision for the calculation of depreciation and makes it mandatory that it is deducted from the total revenue as per any or all of the provisions of the Act which require the deduction of depreciation.
Section 123 states that the depreciation shall be calculated as per the provisions of Schedule II of the Companies Act, 2013. Thus, Section 123(1)(a) talks about the mandatory provision of deducting depreciation to arrive at a final profit statement, which is required by Section 198, and Section 123(2) states that depreciation shall be calculated as per the provisions of Schedule II.
Schedule II of the Companies Act, 2013, read along with Section 123 of the Act, essentially deals with the determination of depreciation. While Section 198 directs towards Section 123, the latter ultimately reflects the legal provision that depreciation as per the Companies Act, 2013, which is calculated as per the provisions of Schedule II.
Schedule II takes into account the useful lives of assets to calculate depreciation. Useful life refers to the period for which an asset will be used in a company or manufacturing facility. Schedule II is divided into three parts: Parts A, B, and C, which enlist certain provisions for the calculation of depreciation. Let us understand them in more detail.
Part A of Schedule II begins with an explanation of the term “depreciation.” Part A Clause (1) describes depreciation as the determination of the depreciable value of an asset with the passage of its useful life. The depreciable amount is determined as the initial value of an asset less its residual value. The useful life of an asset can be reflected as the period of time for which the asset will be put to use, or the total production (in terms of the number of units or otherwise) for which the asset will be used by an industry or company.
Part A of Schedule II also states that depreciation includes amortisation for the purpose of this schedule. Amortisation refers to the decrease in the cost of an asset over time. It is usually used to determine the value of intangible assets like copyrights, trademarks, patents, etc., which also lose value with time. This loss in value is determined through amortisation. Amortisation uses the straight line method to calculate depreciation in the value of an asset for the company. Intangible assets do not have any salvage or resale value at the end of their useful life, thus, the value of depreciation through each year of their useful lives using the straight line method remains uniform. Clause 2 of Part A states that depreciation includes amortisation for the purpose of this Schedule and thus, the annual amortisation value is added to the annual financial statement of the company.
Part A of Schedule II also talks about the specifications for the useful life of an asset. It states that the useful life of an asset will be as long as the period mentioned in Part C of the schedule for each asset or class of assets. Further, it states that the residual or salvage value of the asset shall be approximated at not more than five percent of the initial value (purchasing value) of the asset. If a situation ever arises where a company wishes to exceed these specified limits for the residual value of an asset or the useful life period, the company must disclose the same in their financial statements. Such disclosure shall also explain the plausible reasons for exceeding the limit. The reasoning will be complemented with relevant technical aid as justification for exceeding the limit.
In the case of intangible assets, whose depreciation is calculated using the method of amortisation, the Indian Accounting Standards (Ind AS) become applicable. In cases where the Indian Accounting Standards will not be applicable, the provisions related to essential accounting standards under the Companies (Accounting Standards) Rules, 2006, will become applicable. The only exception to this requirement is the intangible assets (toll roads) under “Build, Operate, and Transfer” or any other form of road projects built, owned, operated, or transferred under any public-private partnership routes.
Part A of Schedule II also determines and prescribes the mode of amortisation for the relevant assets. As per these provisions,
Amortisation rate = Amortisation Amount / Cost of Intangible Assets x 100
Amount of Intangible Assets x Actual Revenue of a year
Amortisation Amount = __________________________________________________
Projected Revenue from Intangible Assets for that year
(till the end of concession period)
In these modes of calculation,
Cost of intangible assets = cost incurred by the company in intangible assets in a given accounting year,
Actual revenue = revenue generated/received (Toll Charges) during an accounting year,
Projected revenue = the sum total of the projected revenue from intangible assets, provided to the project lender at the time of financial closure.
Therefore, the calculation of depreciation under the Companies Act, 2013, also includes the amortisation of intangible assets under this established method. The entire amount arising from the intangible assets must be amortised over the concession period. At the end of an accounting year, the revenue is reviewed. During this time, adjustments and changes are made in accordance with the projected revenue. Therefore, final estimates are calculated during this time.
Part B talks about the overriding effect of government norms or regulations regarding the calculation of depreciation over other rules and regulations under the Companies Act, 2013. Part B states that in cases where the useful life or salvage value determination of any asset or classes of assets is specified by any regulatory authority for the purposes of accounting, under the authority of the Central Government or through any Act of Parliament, such accounting provisions will be applied to those specific assets, irrespective of the provisions related to them in Schedule II of the Companies Act, 2013.
Thus, when a regulatory authority of the government prescribes the useful life or the rate of residual value for an asset or classes of assets, the company using those assets must use the government-specified values for determining depreciation for those assets, even if they are different from the rates determined by the management of the company.
For instance, the Ministry of Power of the Government of India, vide its notification dated January 6, 2006, specified the tariff policy with reference to Section 3 of the Electricity Act, 2003. This policy specifies that the specified rates under this notification by the Central Electricity Regulatory Commission (CERC) shall be applicable for both purposes—tariffs as well as accounting. Therefore, the companies that are regulated by this notification shall apply these provisions of the Ministry of Power of the government instead of Schedule II of the Companies Act, 2013.
Part C of Schedule II of the Companies Act, 2013, prescribes a list of the useful lives of various tangible assets and their classes. Part C determines the useful life of the following classes of assets:
NESD refers to “no extra shift depreciation.” It refers to the assets where no extra depreciation is charged when those assets are used for extra shifts than usual, which is one shift.
Part C of Schedule II talks about the specific useful lives for all the tangible assets that may fall into either of these above-mentioned categories. For instance, refineries, oil and gas assets, petrochemical plants, storage tanks, and related equipment under the category of specific plants and machineries have 25 years of estimated useful life as per this list in Part C. Similarly, general furniture and fittings have an estimated useful life of 10 years, and likewise, the list goes on. Part C further clarifies that factory buildings do not include offices, godowns, or staff quarters.
There may be instances when an asset (or assets) are added in the middle of a financial year. At times, existing assets may have been sold, rejected, thrown away, demolished, or destroyed before the financial year ends. In these circumstances, the depreciation of these assets will be calculated on a pro-rata basis. For those assets, this calculation is done from the date of addition of the assets, or till the date when the assets were in use in the company until they were destroyed, demolished, rejected, thrown away, or sold.
Further, Part C of Schedule II makes provisions for mandatory disclosure requirements. The company is required to disclose in its annual financial statements the method used for calculating depreciation. Additionally, if the useful life or residual value of the assets used by a company differs from those mentioned in Schedule II, the company must disclose it in its annual financial statements and also specify the other regulation that has been referred to by them.
Sometimes it happens that an asset consists of several assets or parts. Some of these can form a significant part of the asset. Part C of Schedule II prescribes a useful life period for the whole of an asset. However, if the asset consists of a significant part whose useful life is separately prescribed under Part C of this schedule, then the useful life of that asset will be used and the depreciation will be calculated separately. This requirement under the provisions of this schedule was voluntary for the companies to implement for financial years on or after 1st April, 2014 and became mandatory from 1st April, 2015.
Now, assets may be used on a shift-to-shift basis. The useful lives of these assets, as has been enlisted under Part C of Schedule II, are in reference to a single shift of these assets. Thus, when an asset is used for extra shifts than usual, if an asset is used for double shifts during one accounting year, its rate of depreciation increases at the rate of 50% for that period. Similarly, if the asset is utilised for triple shifts, the rate of depreciation will be calculated at a rate of 100% for that period. An exception to this rule is for the assets on which an extra shift depreciation is not applicable.
Depreciation is an essential calculation in determining the profit, loss, and overall revenue statements of a company in a given financial year. When an industry or company runs, there are several tangible and intangible assets that help in the everyday operation of the business. These assets can be machinery, furniture, fittings, and other office equipment, as well as intangible assets like computer software, trademarks, patents, etc. The use of these tangible and intangible assets comes with implied costs. The calculation of the cost of acquiring these assets is different from the cost of them at the end of their useful lives. This difference is known as the depreciation in the value of the assets. The value of an asset decreases when it is used in a company or industry over a period of time. This time period has been referred to as the useful life of assets. The useful life, along with the scrap value or salvage value of the asset, helps in determining the depreciation in the value of that asset. For intangible assets, we calculate the depreciation in the form of amortisation. This amortised value forms part of the total depreciation in the value of all the assets for that company in a given financial year. The total depreciation is deducted from the total revenue of the company in that financial year to calculate the net income of the company in that financial year. The Companies Act, 2013 prescribes an elaborate method for calculating depreciation and the determination of the useful life and residual value of assets.
Calculating depreciation is necessary because it helps in determining the actual value of assets owned by a company and has a direct implication in determining the financial report of the company. If depreciation is not determined, the financial statements of the company will become faulty due to improper and inaccurate information. Therefore, it is mandatory for every company to determine and claim depreciation.
No, it is not mandatory to claim depreciation as per the Companies Act, 2013. Depreciation is claimed for two purposes, accounting purposes and taxation. When the motive behind claiming depreciation is for accounting purposes, depreciation is usually calculated under the provisions of the Companies Act, 2013. However, a company can choose to claim it under the Income Tax Act, 1961. The procedures used in both contexts differ, but the end result is determining the depreciation of assets. Under the Income Tax Act, 1961, a company can claim depreciation on assets that can be put under the category of “income from business and profession.”
Students of Lawsikho courses regularly produce writing assignments and work on practical exercises as a part of their coursework and develop themselves in real-life practical skills.
LawSikho has created a telegram group for exchanging legal knowledge, referrals, and various opportunities. You can click on this link and join:
Follow us on Instagram and subscribe to our YouTube channel for more amazing legal content.
