We can apply the concept of depreciation in both accounting as well as tax calculations. In this article, we will see how Accounting Depreciation differs from Tax Depreciation, but before that, let us first understand what is depreciation and how it matters.
We can define "depreciation" as a concept that is applied for the purpose of writing off the cost of an asset over its useful life. Companies have different types of tangible assets such as plant machinery, factory equipment, vehicles, etc. The fair value of such tangible assets reduce over a period of time. This is what we call "depreciation". It is a method of spreading the cost of a tangible asset over a period of time due to decreases in the fair value of the asset.
Depreciation of assets is an important factor while calculating the value of a business, because depreciation of assets implies the business is losing its value over time. An ageing plant with old machinery will be less valuable than a new plant with sophisticated equipment.
Companies sometimes mortgage their tangible assets to secure financing. As the assets lose value due to depreciation, it becomes difficult for companies to get loans against such assets.
Depreciation is a non-cash item and it does not represent an actual cash flow. Nevertheless, depreciation costs are invariably included in the financial statements as expenses and deducted from the net income. If the effects of depreciation costs are not factored in the revenues, then it can be detrimental for the company because it is underestimating the actual costs of operation.
In accounting, depreciation of tangible assets is treated as an expense. At the time of calculating the net income, such depreciation costs are deducted from the company's revenues.
In tax calculations, depreciation costs are used as a means to reduce the taxable income of the taxpayer. Under the Income Tax Act, depreciation costs are eligible for tax deductions. The rate of depreciation varies for different types of tangible assets. For example, the rate of depreciation for furniture is 10%, whereas it is 15% for vehicles that are used in business operations.
Note that "Land" is a type of tangible asset that does not depreciate in value. Rather, the value of Land appreciates significantly over a period of time.
Tangible assets keep losing their value due to wear and tear. Depreciation helps one understand how much value they have lost and these are expenses that must be factored in the revenues to calculate the actual profitability of a company.
Accounting depreciation is the cost of a tangible asset allocated by a company over the useful life of the asset. Most accounting standards require companies to disclose depreciation on their balance sheet. It reflects the true value of the assets as they age and become less valuable.
How to Calculate Accounting Depreciation?
Following are the two common methods to calculate Accounting Depreciation −
Straight-line method − In this method, the depreciation costs are equally distributed over all the periods of an asset's useful life. For example, at 10% depreciation, the entire cost of a furniture will be written off in the next 10 years. This is also known as Written Down Value (WDV) method.
Accelerated depreciation method − In this method, the rate of depreciation is higher in the earlier periods of an asset's useful life. The depreciation expenses reduce in the subsequent periods and become almost negligible towards the end of an asset's useful life.
Depreciation has an important role to play while calculating tax liabilities. If a company is not accounting for its depreciation costs, then all those costs will add up in the income for which the company is liable to pay a higher tax.
Tax depreciation is the depreciation expenses that a taxpayer can claim on the tax returns. It is a type of deduction that tax authorities provide the taxpayers so that they can reduce their taxable income.
Criteria to Claim Tax Depreciation
Not all types of assets are eligible for tax depreciation. There may be different tax rules for depreciation in every tax jurisdiction, however the following set of points are regarded as the basic rules for an asset to become eligible for tax depreciation −
The asset must be owned, partly or in whole, by the taxpayer who is claiming the deduction.
The asset must be in use in business operations to generate profit.
The asset must have a well-defined useful life and it should be more than one year at least.
"Land" is not regarded as an asset on which the taxpayer can claim depreciation, because the value of land appreciates over time.
The tax authorities in most jurisdictions have a set of guidelines with detailed specifications as to the types of assets on which tax depreciation can be claimed and the rate of depreciation for each type of asset.