Guide to Understanding Depreciation – Meaning | Reasons | Deferred Tax

By CA. Ankur Agrawal – Faculty | Taxmann Academy

Depreciation refers to the accounting process of allocating the cost of a tangible asset over its useful life. In essence, it represents the decrease in the value of an asset over time due to factors like wear and tear, obsolescence, or age. This concept is crucial in accounting because it helps businesses spread the expense of an asset over the years it is expected to be used, rather than just accounting for the entire cost in the year it was purchased. It enables companies to generate revenue from an asset while expensing a portion of its cost each year the asset is in use, reflecting a more accurate financial picture of the company's earnings and asset values.

Table of Contents

1. Meaning of Depreciation
2. Reasons for Charging Depreciation
3. Depreciation as per Income Tax Act
4. Depreciation as per Companies Act
5. Inputs Required for Calculation
6. Deferred Tax – How to Calculate?

1. Meaning of Depreciation

Depreciation is the permanent and continuous decrease in the book value of a depreciable fixed asset due to use, effluxion of time, obsolescence, expiration of legal rights or any other cause.

2. Reasons for Charging Depreciation

• To ascertain True Financial Performance & Financial Position
• To comply with Legal Requirements
• To accumulate Funds for Replacement of Assets

3. Depreciation as per Income Tax Act

Condition

• Charged on Capital Assets
• Block of Assets
• Owned by the Assessee and used for business purpose only
• WDV Method of charging
• No depreciation in year of sale

3.1 Accounting Method as per Income Tax Act

• It is charged to asset Journal Entry
• Journal Entry
  • Depreciation A/c Dr.
    • To Asset A/c

4. Depreciation as per Companies Act

• No Specific rates
• SLM, WDV & UOP Method allowed
• Based on useful Life
• Useful Life given in Schedule II
• Residual Value not exceeding 5%
• Justification is required if there is variation in useful life and residual value

4.1 Method of Accounting

• Provision for depreciation is created
• Depreciation A/c Dr To Provision for depreciation A/c

5. Inputs Required for Calculation

• Original cost
• Date of Purchase
• Particulars of asset
• Residual Value
• Double shift or triple shift (only for few Assets)

6. Deferred Tax – How to Calculate?

6.1 Deferred Tax Asset

• When Depreciation as per IT Act is LESS than as per the Companies Act, It will result in Deferred tax Asset.
• Journal Entry
  • Deferred Tax Asset A/c Dr
    • To P&L A/c

6.2 Deferred tax Liability

• When Depreciation as per IT Act is MORE than as per the Companies Act, It will result in Deferred tax Liability.
• Journal Entry
  • P&L A/c Dr
    • To Deferred Tax Liability