Depreciation in Financial Statements: Compliance, Calculation, and Implications

Under the Companies Act in many jurisdictions, it is a mandatory requirement for companies to charge depreciation in their financial statements. This article discusses the necessity of charging depreciation, the relevant regulations, and the practical implications.

Compliance with Accounting Standards

Compliance with applicable accounting standards such as International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles (GAAP) is crucial. These standards mandate the systematic allocation of the depreciable amount of an asset over its useful life. Charging depreciation ensures accuracy and transparency in financial reporting.

Ensuring a True and Fair View

The act of charging depreciation helps present a true and fair view of a company's financial position. Without charging depreciation, assets would be overstated, leading to an inflated representation of profits. Accurate depreciation allows for a realistic assessment of asset value over time.

Tax Implications

In many jurisdictions, depreciation is a deductible expense for tax purposes. Proper accounting for depreciation can significantly reduce the company's taxable income, providing a financial advantage. Complying with tax regulations regarding depreciation is essential for tax planning and compliance.

Regulatory Requirements

The Schedule II of the Companies Act 2013 clearly outlines the rules, rates, and useful life of assets. Depreciation is to be charged based on the cost of the asset less its residual value, spread over the number of useful years. This method, known as the Straight Line Method (SLM), ensures a consistent and systematic approach to asset valuation.

Example Calculation

For instance, if the cost of an asset is Rs. 25,000 and its residual value is Rs. 5,000 with an expected life of 5 years, the depreciation would be calculated as follows:

Depreciation (25,000 - 5,000) / 5 Rs. 4,000 per year.

Income Tax Calculations

For Income Tax Act 1961, depreciation is calculated using the Written Down Value (WDV) method. Here, depreciation is calculated at a fixed percentage each year on the decreasing book value of the asset. For example, if the initial value of the asset is Rs. 25,000 and the depreciation rate is 20%, the calculations would be:

First year: Depreciation 25,000 * 20% Rs. 5,000Second year: Book value 25,000 - 5,000 Rs. 20,000; Depreciation 20,000 * 20% Rs. 4,000Third year: Book value 20,000 - 4,000 Rs. 16,000; Depreciation 16,000 * 20% Rs. 3,200

Profit and Loss Account and Balance Sheet

For Profit and Loss Account and Balance Sheet, depreciation should be provided as per the Companies Act 2013. However, for Income Tax purposes, the depreciation calculated under Income Tax Act 1961 is used. To compute Income Tax payable, the depreciation under the Companies Act is added to the profit before depreciation, and the depreciation under the Income Tax Act is deducted to arrive at the net payable amount.

Example

Consider a profit before depreciation of Rs. 50,000:

Profit Rs. 50,000

Add: Depreciation under Companies Act Rs. 4,000

Less: Depreciation under Income Tax Act Rs. 5,000

Net profit for calculating Income Tax payable Rs. 45,000

Thus, it is essential for companies to charge depreciation as per the Companies Act 2013 in their books, primarily to adhere to the regulatory framework and maintain accuracy in financial reporting.