Depreciation and its benefits in flourishing solar Power Industry

I am writing this post looking at the complexity for people to understand depreciation during various financial calculations particularly for Solar Power Plants. Though t am not an expert in this topic but will be mentioning the basic details about the topic based on my understanding from my work experience.

What is Depreciation?

Depreciation is a method of allocating some cost of a tangible long term asset over its useful life and thus, refers to the decrease in value of the asset during its lifetime. All fixed assets except the value of land decreases with the passage of time, thus, Depreciation is only calculated when the asset fulfills the following requirements:

The Depreciable asset has a limited useful life,

  • The useful life of the asset is more than one year,
  • The assets should not be the sales inventory i.e. it should be used in pFoduction of goods and services to run a business

How Depreciation is calculated?

There are various methods used to calculate Depreciation based on time

  • Straight line method
  • Declining balance method and others

For Solar Power projects we generally calculate depreciation using straight line method. Formula for the same is,

"Depreciation ---- (Cost - Residual value) / Useful life"

But for getting some tax benefit companies are alsogiven option to go for accelerated depreciation.

Understanding Accelerated Depreciation

Accelerated Depreciation (AD) refers to any one of several methods by which a company, for 'financial accounting' or tax purposes, depreciates a fixed asset in such a way that the amount of depreciation taken each year is higher during the earlier years of an asset's life. (Definition taken from The benefit of AD in solar power industry is used to incentivize the entrepreneurs to enter into the solar power generation. Section 32 of IT Act provides Accelerated Depreciation of 80 % of the invested capital to professionals companies with tax liability, Investors can thus, set off their tax on the taxable income to the tune of 80% in the 1st year, and subsequently 20% in the 2nd year,

Any company involved in solar power generation can clam either AD or Generation Based incentive (GB1) and not both of them together.

Example for calculation of Accelerated Depreciation

To understand how AD works for solar power proiectsi, let us a sur e the following:

  • Overall project cost : 1NR 700 Lacs for plant and machinery and IN R 100 I. ac for land
  • Book depreciation : 5.28 %
  • (As per Companies Act)
  • Residual Value : 10 %
  • Tax Depreciation rate : 80% (Only on plant and machine)
  • Tax Rate : 33 %

Calculation of book depreciation as per Straight Line Method

Years 1 2 3 4 5
Amount based on the rate given above = 5.28%*700 % 5.28% 5.28% 5.28% 5.28% 5.28%
Book Depredation(A) INR 36.96 36.96 36.96 36.96 36.96

Calculation of depreciation considering Accelerated Depreciation

Years 1 2 3 4 5
Opening   100% 20% 4% 0.8% 0.16%
Dep. Allowed during the year % 80% 16.00% 3.2% 1.92% 0.128%
Closing % 20% 4% 0.8% 0.16%4.48 0.032%
Accelerated Depreciation(B) INR 560.00 112.00 22.40   0.90

Net Benefit

Net Depreciation(B-A) INR 523.04 75.04 -14.56 -32.48 -36.06
Tax Benefit @ 33% on Net Depr. INR 172.60 24.76 -4.80 -10.72 -11.90

Thus, it can be concluded here that for a solar power plant taking benefit of  AD, the net cost of the plant for the first year will come to be INR 527.40 Lacs  (f-NR 700 - !NR 172.60) only instead of INR 700 Lacs, This helps Power Generators to save some money in the initial years which can then be used for repayment of debt. And this is all about depreciation a person should know for making financial calculations for a Solar Power Plant.

AD has been a boon for small investors and overall a nice initiative by the Government. It may or may not continue in future depending on the cost rut down in solar power industry.