Depreciation Rules in Companies Act 2013

Table of Contents

• Introduction
• Understanding Depreciation under the Companies Act 2013
• Key Terms and Concepts
• Methods of Depreciation
  • Straight Line Method (SLM)
  • Written Down Value Method (WDV)
  • Unit of Production Method (UOP)
• Calculation of Depreciation: The Role of Schedule II
• Key Features of Schedule II
• Amendments in Depreciation Rules Since 2013
  • Component Accounting and Flexible Useful Lives
  • Transitional Provisions
  • Impact on Financial Statements and Deferred Tax
• Practical Implications for Companies
• Recording and Disclosures in Financial Statements
• Conclusion

Introduction

Depreciation is a fundamental concept in accounting, representing the systematic allocation of the cost of an asset over its useful life. Under the Companies Act 2013, depreciation is not merely a regulatory requirement—it’s a crucial tool that affects a company’s profitability, tax liabilities, and asset management strategies. In this article, we will explore the rules on depreciation laid down in the Companies Act 2013, discuss the methods prescribed, and look at the recent amendments that have provided companies with more flexibility in determining useful life and component accounting.

Understanding Depreciation under the Companies Act 2013

At its core, depreciation is the process of allocating the depreciable amount of an asset—that is, the cost of the asset minus its residual value—over its useful life. This allocation reflects the wear and tear, obsolescence, and the passage of time. The Companies Act 2013 moves away from fixed “prescribed rates” (as seen in the old Companies Act, 1956) and instead focuses on the concept of “useful life.”

Key Terms and Concepts

Depreciable Amount: The depreciable amount of an asset is defined as its original cost (or the amount substituted for cost) minus the residual value. This residual value should not exceed 5% of the original cost.

Useful Life: This is the period over which an asset is expected to be available for use by the entity or the number of production or similar units expected to be generated from the asset. Schedule II of the Companies Act 2013 provides indicative useful lives for various asset classes.

Residual Value: Residual value is the estimated value of an asset at the end of its useful life. The Act stipulates that this value should not exceed 5% of the asset’s original cost unless justified otherwise.

Component Accounting: An important modern concept introduced in the Companies Act 2013 is the requirement for component accounting. If an asset has parts whose costs are significant relative to the total asset cost and have different useful lives, each part should be depreciated separately. This approach ensures a more accurate reflection of asset value over time.

Methods of Depreciation

The Companies Act 2013 permits companies to choose from three main methods of depreciation:

Straight Line Method (SLM)

Under the Straight Line Method, the depreciable amount of the asset is spread evenly over its useful life. For example, if a company purchases a machine for ₹100,000 with a residual value of ₹5,000 and an expected useful life of 5 years, the annual depreciation charge will be:

Annual Depreciation = ₹ 100,000 – ₹ 5,000 / 5 = ₹ 19,000

This method is popular for assets that provide a consistent benefit over time, such as buildings or office furniture.

Written Down Value Method (WDV)

The Written Down Value Method allocates a higher depreciation charge in the early years and lower charges in later years. The depreciation for each period is computed on the asset’s opening written-down value. For instance, if a machine is purchased for ₹100,000 and the depreciation rate is determined (based on the useful life and residual value), the first year’s depreciation is calculated on ₹100,000, and subsequent years are based on the remaining written-down value. This method is particularly suitable for assets that lose value more rapidly in the initial years of use, such as vehicles or computer equipment.

Unit of Production Method (UOP)

Although less commonly applied, the Unit of Production Method bases depreciation on the actual usage or production output of the asset. In this approach, depreciation is calculated as:

Per Unit Depreciation = Cost – Residual Value / Total Expected Units

This method is ideal for assets where usage directly correlates with wear and tear, such as manufacturing machinery.

Calculation of Depreciation: The Role of Schedule II

Schedule II of the Companies Act 2013 is central to the calculation of depreciation. Rather than prescribing fixed depreciation rates, it provides indicative useful lives for different classes of assets. Companies must either adopt these useful lives or, if they choose different estimates, disclose the reasons along with technical justification in their financial statements.

Key Features of Schedule II

• Indicative Useful Lives: Schedule II lists the useful lives for various assets such as buildings, machinery, vehicles, furniture, etc. For example, an RCC frame structure building has a useful life of 60 years, while a non-RCC building may have a useful life of 30 years.

• Residual Value: The residual value is capped at 5% of the original cost, which acts as a benchmark in the calculation of depreciation.

• Component Approach: Companies are required to account for significant parts of an asset separately if these parts have different useful lives. This ensures that the depreciation charge is not overstated or understated.

• Extra Shift Depreciation: For assets used in multiple shifts, the Act provides for additional depreciation. Specifically, if an asset is used for double shifts during any period, depreciation for that period is increased by 50%. For triple shifts, the increase is 100%. Assets marked as NESD (No Extra Shift Depreciation) do not attract this additional depreciation.

Amendments in Depreciation Rules Since 2013

Although the core concept of depreciation under the Companies Act 2013 has remained consistent, there have been a few notable amendments aimed at providing greater flexibility and aligning the rules with evolving business practices. These amendments include:

Component Accounting and Flexible Useful Lives

• Component Accounting: Initially, companies were encouraged to use the useful lives specified in Schedule II. However, subsequent amendments have made component accounting mandatory for significant parts of assets. This change requires companies to determine the useful life of major components separately, which can result in more accurate depreciation charges.

• Flexible Useful Lives: Companies now have the option to adopt a useful life or residual value different from the indicative figures provided in Schedule II, provided they offer sufficient technical justification and disclose this in their financial statements. This amendment acknowledges that advances in technology and differences in asset usage across industries may necessitate a deviation from the standard figures.

Transitional Provisions

For assets held by companies on 1st April 2014, the transition rules require that the carrying amount (i.e., the written-down value) as on that date be depreciated over the remaining useful life specified in Schedule II. If the asset’s useful life has already been exhausted, the excess amount (over the residual value) is written off against retained earnings. These provisions ensure a smooth transition from the old depreciation rules under the Companies Act, 1956, to the new framework under the Companies Act 2013.

Impact on Financial Statements and Deferred Tax

Because depreciation methods under the Companies Act 2013 are based on the useful life and residual value, differences may arise between accounting depreciation and tax depreciation (as per the Income Tax Act, 1961). These differences lead to temporary differences that create deferred tax liabilities or assets in the financial statements. The amendments emphasize the need for companies to disclose these differences and provide adequate explanations in their notes.

Practical Implications for Companies

The revised depreciation rules under the Companies Act 2013 have far-reaching implications:

• Improved Accuracy in Financial Reporting: By focusing on the useful life of assets and requiring detailed disclosure when deviations occur, the Act ensures that asset values are represented more accurately in financial statements. This helps stakeholders get a clearer picture of a company’s financial health.

• Enhanced Transparency: The requirement to disclose and justify any departures from Schedule II’s indicative useful lives increases transparency. Auditors and regulators can better assess whether the depreciation charged is reasonable, which ultimately protects the interests of investors and creditors.

• Flexibility for Different Industries: Different industries may have assets that depreciate at different rates due to technology, usage patterns, or market conditions. The flexibility to adjust useful lives and the introduction of component accounting mean that companies in capital-intensive industries can now reflect the true economic wear and tear on their assets.

• Tax and Deferred Tax Impact: Since the Companies Act 2013’s depreciation rules differ from those under the Income Tax Act, companies may experience a temporary difference in depreciation expense. This difference must be accounted for as deferred tax liability or asset, affecting the overall tax burden reported in the financial statements.

• Transition Challenges: Companies with assets purchased before 2014 may face higher depreciation charges if their assets have already been depreciated under the old rules and now need to be recalculated over the remaining useful life. This can impact profitability and may necessitate adjustments in retained earnings.

Recording and Disclosures in Financial Statements

Proper recording of depreciation is crucial. Companies should ensure:

• Depreciation Expense: This is recorded as an expense in the Profit and Loss Account, matching the cost of asset usage to the revenue generated during the period.

• Accumulated Depreciation: This is shown on the balance sheet as a reduction from the original cost of the asset, indicating the total depreciation charged over the asset’s life.

• Notes to Financial Statements: Any significant changes in useful life, residual value, or methods of depreciation should be disclosed along with the technical rationale behind them. This transparency is essential for investors and regulators.

Conclusion

Depreciation under the Companies Act 2013 represents a paradigm shift from fixed rates to an estimation based on useful life and residual value. By emphasizing component accounting and allowing for flexible useful lives, the Act seeks to ensure that asset values are reported more accurately and transparently. These changes have significant implications for financial reporting, tax computation, and business planning.

While the core rules have remained intact since 2013, amendments—especially those regarding component accounting and the flexibility to deviate from Schedule II’s indicative useful lives—have provided companies with the ability to better align depreciation charges with real-world asset usage. As companies navigate these rules, it is crucial to maintain robust documentation and disclosure practices, ensuring that financial statements reflect a true and fair view of the company’s financial position.

For business owners, accountants, and auditors, a thorough understanding of these depreciation rules is essential to avoid discrepancies in financial reporting and ensure compliance with statutory requirements. In today’s fast-evolving business environment, these guidelines not only enhance transparency but also help companies manage their assets more efficiently.