Depreciation Riddle under Two Different Acts

Let’s begin this discussion with a question asked by one of the students in my class Sir, is depreciation method different under accounting and income tax? Simple question but very relevant in accounting and tax world.

This is the puzzled question Arnab, a management student with no finance background, asked during my tax class. Let’s understand this concept of deprecation—

Depreciation is an important concept in accounting and finance. It signifies a non-cash expense reflecting the declining value of business assets due to wear and tear, obsolescence, or simply the passage of time. For businesses in India, there are two primary laws governing how depreciation should be calculated—the Companies Act, 2013 and the Income Tax Act, 1961.

Depreciation charged on the depreciable asset is treated as an expense in the Profit & Loss Account. The purpose of depreciation is to charge to Profit & Loss A/c, a portion of an asset that relates to the revenue generated by that asset, which is the example of matching principle, where revenues and expenses both appear in the Profit & Loss A/c in the same accounting period

Knowledge of accounting and income tax law is necessary to solve this puzzle! Why depreciation is different under the Companies Act, 2013 and the Income Tax Act, 1961.

Depreciation is claimed by the company for two purposes:

1. Accounting Purpose and
2. Taxation Purpose.

In accounting depreciation focuses on two aspects – a decrease in the value of the assets and sharing of the cost of assets to the useful life of the assets. The depreciation is calculated on the basis of the useful life of assets (Schedule II of the Companies Act, 2013) and not on the basis of the rate of depreciation.

Under Income Tax Act 1961, depreciation is charged on the block of assets (Sec. 32) under Written Down Value method at the rates specified in the Income Tax Act in that regard. It is allowed as an expense to the company while arriving at income under the head of income from business and profession (PGBP).

Let’s go through this story of two friends where they are doing business– Mr. Singh and Mr. Sen

 Mr. Singh and Mr. Sen, bought a new machine worth ₹10 lakh.

• Mr. Singh wanted to save tax and followed the Income-tax Act, 1961.
• Mr. Sen wanted to focus on financial performance of the company, so he followed the Companies Act, 2013.

• Depreciation under the Income-tax Act, 1961

1. Method: Only Written Down Value (WDV) method allowed.
   1.  System: Block of assets (not individual assets)
   1. Rates: Given under Rule 5 of Income-tax Rules, 1962 (e.g., 15% for machinery, 40% for computers, 10% for buildings.
   1. Half-year rule: If put to use for less than 180 days, only 50% depreciation allowed.
   1. Additional depreciation: 20% for new plant & machinery in manufacturing (Sec. 32(1)(iia))
   1. Objective: Reduce taxable income

• Depreciation under the Companies Act, 2013

1. Governing provision: Section 123 read with Schedule II
2. Method: Straight Line Method (SLM) or WDV
3.  Basis: Useful life of each asset, not block system
4. Residual value: Maximum 5% of original cost
5. Flexibility: Companies can adopt a different useful life than prescribed, but must justify in notes.
6.  Objective: Show a true & fair view of profits for stakeholders

 Reasons for this conflict

As the depreciation methods differ for taxation and for accounting purpose, the amount of depreciation as per Income Tax Act and as per the Companies Act also differs

Example: For the same machine worth ₹10 lakh –

• As per Companies Act: Depreciation based on useful life (say, ₹60,000 in Year 1).
• As per Income-tax Act: Depreciation at 15% WDV (₹1,50,000 in Year 1).

Difference = ₹90,000.

This difference affects taxable income and book profit. This will give rise to a timing difference, which requires to be quantified in the financial statements in the form of Deferred Tax Asset (DTA) and Deferred Tax Liability (DTL).

Deferred Tax Asset (DTA) arises when a company pays more tax now but will save tax in the future. Deferred Tax Liability (DTL) arises when a company pays less tax now but will have to pay extra tax later.

 When I asked Arnab, is it clear now?

Arnab nodded and started discussion with his friends with lot of excitement on this topic!  

Pay Attention

1. Understand why two depreciation systems exist
2. Identify the link between Sec. 32 (IT Act) and Sec. 123, Schedule II (Companies Act)
3. Grasp how it affects income statement.
4. Depreciation differences create DTAs/DTLs.

Closing Memo

Depreciation is not just about calculation applying rates only – it’s about understanding how judiciously it is recorded in financial statement to reflect a true and fair view of the business to all the stakeholders.