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What is Depreciation?
When an entity acquires a Capital Asset, it will be a Balance Sheet Item. There is wear and tear of an Asset in use and results in a reduction in the value of the same. The deduction is in the form of Depreciation and is available over the life of that respective Asset. The deduction is allowed in the form of allowance every year, called Depreciation.
In brief, depreciation is a Capital Allowance towards Fixed Assets and allowed as a deduction from the Revenue/Income before arriving at the taxable Profit/Income.
At the end of this article, we will study, how the purchase of a costlier asset for claiming higher depreciation affects Cash Flow in the year of acquisition and Working Capital over the life of an Asset. Viz. Car, Laptop, Mobile Phone, etc.
When an entity purchases an Asset for its business, it will be a capital expenditure and will not be treated as an expenditure and will not get debited to Profit and Loss Account, but forms the part of the Balance Sheet.
Capital Expenditure :
It is an expenditure incurred for the addition of an Asset to the business and always forms a part of a Balance Sheet.
The examples of Capital Expenditure
- Purchase of Land
- Purchase of Building
- Purchase of Computers
- Purchase of Computer Peripherals
- Purchase of Software
- Purchase of Vehicle/s.
- Purchase of Phone
- Purchase of Computers / Laptops
- Purchase of Plant and Machinery
- Freight, Installation costs of Plant and Machinery. i.e. the costs that are ancillary or incidental in the process of acquisition of such Asset.
- In case of purchase of 2nd Hand machine, costs incurred on repair and overhauling before putting it in use are considered as ancillary or incidental and get capitalized along with an Asset.
Revenue Expenditure :
It is a normal expenditure incurred in a day-to-day business for running its activity. It is also a part of working capital and will be allowed as a deduction from revenue. It forms a part of a Profit and Loss Account or an Income and Expenditure Account.
Tangible and Intangible Asset :
Tangible Assets are Assets that are Tangible in nature. You can see it, touch it and feel the same.
Whereas Intangible Assets are Assets that are not Tangible in nature. i.e. You can’t see, touch, and feel the same but can use it. Eg. Software.
The Depreciation is calculated on the Cost of an Asset + Incidental Costs – Salvage Value.
Methods of Depreciation | Formula of calculation of Depreciation :
There are two methods | Formulas of Depreciation.
- Straight Line Method – It calculates the depreciation at a Fixed-rate based on the life of an Asset. It is calculated on the original cost of an Asset less Salvage value and remains fixed over a period of time.
- Written Down Value (WDV) Method – It calculates depreciation at the rate on the closing value of an Asset after depreciation of last year.
Salvage Value :
The salvage value is the value of the asset, that may fetch at the time of sale or disposal of an Asset after its life of utilization. It is an estimated resale value that could receive at the time of sale after the utilization of the useful life of an Asset.
| Asset | Plant and Machinery |
| Life | 10 years |
| Rate of Depreciation (Income Tax Act) | 15% |
| Purchase Price | 10,00,000 |
| Salvage Value | 1,00,000 |
| Depreciable Value | 9,00,000 |
| Straight Line Method (SLM) | Written Down Value (WDV) Method | |||
| Depreciable value | 9,00,000 | Depreciable value | 9,00,000 | |
| Life of an Asset | 10 Years | Rate of Dep. (Income Tax Act) | 15% | |
| SLM Dep. (ROC / Co. Act.) | 90,000 | WDV Dep. (Income Tax Act) | As below | |
| Value of Asset | 10,00,000 | Value of Asset | 10,00,000 | |
| Dep. (Year 1) | 90,000 | Less : Dep. Year 1 (@ 15% on above) | 1,50,000 | |
| WDV (Closing Value) | 9,10,000 | WDV (Closing Value) | 8,50,000 | |
| Dep. (Year 2) | 90,000 | Less : Dep. Year 1 (@ 15% on above) | 1,27,500 | |
| WDV (Closing Value) | 8,20,000 | WDV (Closing Value) | 7,22,500 | |
| Dep. (Year 3) | 90,000 | Less : Dep. Year 1 (@ 15% on above) | 1,08,375 | |
| WDV (Closing Value) | 7,30,000 | WDV (Closing Value) | 6,14,125 | |
| Dep. (Year 4) | 90,000 | Less : Dep. Year 1 (@ 15% on above) | 92,119 | |
| WDV (Closing Value) | 6,40,000 | WDV (Closing Value) | 5,22,006 |
I saw some businessmen buy costly Assets for claiming higher Depreciation. The thinking is to get high expenditure and reduce the profit to save the tax.
No doubt, it will reduce the profit. But will impact Cash flow so on the working capital, which could have been used in furtherance of business.
Eg.
Buying of iPhone instead of Android phone.
Buying of Scoda or Mercedes car, instead of Maruti Car.
Buying of Apple Laptop instead of Normal Laptop. Etc…
Buying a costly Asset, result in Cash outflow in the year of acquisition due to Investing Activity in the Cash Flow Statement. The depreciation claim, will not affect the Cash Flow.
Impact of depreciation on the pocket in the below situations.
Situation 1 : Buying of normal car for use in Business
Situation 2 : Buying of costly Car only to claim higher depreciation expenses in Business.
Since you can afford this, we will assume that you are in the 30% of income Tax bracket. And the Depreciation as per Income Tax Act is @ 15%.
| Situation 1 | Situation 2 | |
| Cost | 10,00,000 | 30,00,000 |
| Profits taxed @ | 30% | 30% |
| WDV Depreciation (As per Income Tax Act) @ | 15% | 15% |
| Dep. claim in Year 1 | 1,50,000 | 4,50,000 |
| Dep. claim in Year 2 | 1,27,500 | 3,82,500 |
| Dep. claim in Year 3 | 1,08,375 | 3,25,125 |
| Dep. claim in Year 4 | 92,119 | 2,76,356 |
| Dep. claim in Year 5 | 78,301 | 2,34,903 |
| Total Depreciation | 5,56,295 | 16,68,884 |
| Tax Saving due to Depreciation Claim @ | 30% (Tax Rate) | 30% (Tax Rate) |
| Tax Saving in Year 1 | 45,000 | 1,35,000 |
| Tax Saving in Year 2 | 38,250 | 1,14,750 |
| Tax Saving in Year 3 | 32,513 | 97,538 |
| Tax Saving in Year 4 | 27,636 | 82,907 |
| Tax Saving in Year 5 | 23,490 | 70,471 |
| Total Tax Saving | 1,66,888 | 5,00,665 |
| Analysiing the benefit : | ||
| Investment blocked (Dep.-Tax Saving) | 3,89,406 | 11,68,219 |
| (Depreciation – Tax Saving) | ||
| Incremental Investment Blocked due to Situation 2 | 7,78,813 |
In the above example, we have considered the depreciation only for 5 years. You can calculate the same for further years.
If you think of buying of costly asset viz. Mobiles, Laptops, Cars, etc. than its normal use, please analyze before making such investment.
This study is based on the normal fund crunch faced by normal start-up businesses.
Please take the advice from your financial advisor before making any decision. This article is written only for study purposes.
