The measurement of erosion in the monetary value of an asset over a while due to its regular use, wear, and tear, or obsolescence is known as depreciation. It has been defined under Accounting Standard-6 as “a measure of the wearing out, consumption or other loss of value of a depreciable asset arising from use, efflux of time or obsolescence through technology and market changes.” For a business entity, it is an expense involving no cash outflow. It is charged to a business entity’s profit and loss account concerning the revenue generated by that asset. It is important in arriving at an actual financial position and the final result of a company’s operations.
Schedule II of section 123 of the Companies Act 2013 stipulates the conditions to be complied with while making provisions for the depreciation of a company’s assets. The said Act/schedule, which became effective on 1″ April 2014, brought about significant changes in how the company provided the depreciation on assets before that date.
Key Concepts under Depreciation
The following concepts and terminologies are important for depreciation-related matters.
1. Depreciable Amount
Depreciable Amount of an Asset =Cost of an Asset (any other amount substituted for cost)- Residual Value [Note: Residual value of an asset should not exceed 5% of the asset’s original cost).
If, during a particular financial year, there is some addition to an asset or an asset has been removed from the books of a company by way of having been sold, discarded, demolished, or destroyed, the calculation of depreciation on such assets needs to be carried on a pro-rata basis from the date of such addition or, upto the date on which such asset has been removed from the company’s books by way of having been sold, discarded, demolished or destroyed, as the case may be.
In terms of various provisions of the erstwhile Companies Act 1956, depreciation on a depreciable asset was required to be provided in such a manner to ensure that 95% of its original cost was written off over a specified period. The remaining 5% of that asset’s original cost had to be treated as residual value. However, if an asset costs less than 25,000, it could have been charged 100%.
The matter has been made clear in the Companies Act 2013, according to which the residual value of any asset can be at most 5% of its original cost. The enabling provision of the erstwhile Companies Act relating to charging depreciation @ 100% in case of an asset having its actual cost less than 5,000 stands repealed.
2. Useful Life
The useful life of an asset is spread over some time during which the asset is available for use. It (the useful life) may also be defined as the number of units produced by an asset or expected to be produced shortly for the use of the business entity. The useful life for 15 categories of tangible fixed assets has been specified in Part-C of the schedule-II of the Companies Act, 2013.
There is wide variation between the above list of the useful life of various categories of tangible fixed assets and what was earlier indicated in Schedule-XIV, the Companies Act, 1956. The new Act has provided more stringent depreciation norms than the earlier ones. Many companies must make higher levels of depreciable provisions in their books. Further, the companies also need to consider the backlog of depreciation on assets not provided for during the earlier years: such backlogs must be amortized during the residual life of those assets.
3. Component Approach
According to the new Act, if a specific component of an asset has a substantial cost and more useful life distinct from other components of that asset, it needs to be treated differently as a separate asset to provide for depreciation. Schedule II of the Companies Act prescribes the application of the Component Approach (as defined under the Indian Accounting Standards-16 (AS-16). The useful life of that significant part of the asset must be determined separately.
Under the component approach, a company is expected to calculate the depreciation on a fixed asset by determining the useful life of a specific component, which is different from other components of that asset, separately. It is necessitated because such information may not be available in Schedule II. Once the useful life of such a component is established, calculating depreciation on that specific component becomes a simple job.
4. Depreciation Rates
Depreciation rates indicated in the Schedule XIV of the Companies Act 1956 were minimum. As such, a company could charge depreciation above the minimum prescribed rates. Schedule II of the Companies Act 2013 has not stipulated such depreciation rates. It may be safely interpreted that a company needs to charge depreciation at uniform rates over the years.
Further, according to Schedule XIV of the Companies Act 1956, there are different depreciation rates for double-shift and triple-shift use of assets. There is no such mention in the above schedule regarding different rates for extra shift depreciation. However, per Schedule II of the Companies Act, 2013, (ESD) applies only to plants and machinery general rate (the useful life of 15 years) and not to NESD items. It further provides the following:
i) 50% more depreciation for that period for which the asset is used for the double shift
ii) 100% more depreciation for that period for which the asset is used for the triple shift
In Schedule XIV of the erstwhile Companies Act, 1956, the rates have been stipulated at which it needs to be provided on various assets using:
- Straight Line Method (SLM)
- Written Down Value (WDV) method
However, the Schedule II of the Companies Act 2013 has provided only the useful life of an asset. A company is, therefore, required to calculate the apt rate of depreciation depending on the method of depreciation (SLM or WDV) adopted by it.