LMT SCHOOL OF MANAGEMENT, THAPAR UNIVERSITYMasters of Business Administration

Course: Financial Reporting and AnalysisFaculty: Dr. Sonia Garg (Email: sonia.garg@thapar.edu)

Session 14: Depreciation of Fixed Assets

Duration: 60 minsSlides: 22

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AS-6 weblinkDepreciation is a measure of the wearing out, consumption or other loss of value of a depreciable asset arising from use, effluxion of time or obsolescence through technology and market changes. Depreciation includes amortisation of assets whose useful life is predetermined.

Depreciable assets are assets which (i) are expected to be used during more than one accounting period; and (ii) have a limited useful life; and (iii) are held by an enterprise for use in the production or supply of goods and services, for rental to others, or for administrative purposes and not for the purpose of sale in the ordinary course of business.

Depreciable amount of a depreciable asset is its historical cost, or other amount substituted for historical cost in the financial statements, less the estimated residual value

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Determinants of depreciation

• historical cost or other amount substituted for the historical cost of the depreciable asset when the asset has been revalued

• expected useful life of the depreciable asset – the period over which a depreciable asset is expected to be used

by the enterprise; or– the number of production or similar units expected to be obtained

from the use of the asset by the enterprise. (depletion of wasting non-regenerative assets)

• estimated residual value of the depreciable asset.

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Methods of Depreciation

Two most common methods• Straight line method (SLM)• Reducing balance or written down value method (WDV)

The management selects the more appropriate method based on the following factors:• Type of asset (prone to fast obsolescence)• Nature of usage of asset (frequent/infrequent)• Circumstances prevailing in the business (plant operating

below its normal capacity)• Tax considerations

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SLM and WDV

SLMDepreciation charge = (cost of asset – estimated residual value)/expected useful life

WDVRate of Depreciation = 1 – [(estimated residual value/cost of asset)^(1/expected useful life)]

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Problem on SLM and WDV

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SLM solution

Annual depreciation is uniform

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WDV solution

Same for SLM and WDV

Annual depreciation is declining

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Other Observations SLM v/s WDV• First year WDV depreciation is 2.37 times that of SLM depreciation. Third

year onwards the trend reverses

• For first two years under WDV– Lower profits and lower tax liability

• On cumulative basis tax liability under both methods will be same if tax rates do not change, but WDV has following advantages– Gain from time value of money by deferring tax liability– Likely gain if tax rates decline in future– Better cash flows for initial years

• The above assumes depreciation rates given by companies act and income tax act are same which is not the case

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Requirements of Companies Act• Act lays down the rates of depreciation in respect of various assets

– if firm estimates the rates to be higher, they can apply the higher rate– if firm estimates the rates to be lower, it can only be applied in accordance with the statute and

has to be disclosed

• 95% of the cost of asset should be considered as depreciable asset value

• Companies are free to choose between SLM and WDV

• Depreciation is charged on pro rata basis

• Double or triple shifts are proportional to number of days worked as double or triple shift

• Disclose– Method of depreciation– Depreciation rate or useful life if different from rates specified in the Schedule 14

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Provisions of Income Tax Act

• Only WDV method is recognised for all except power generation and distribution firms

• Group assets that carry the same rate of depreciation

• Does not allow shift depreciation

• Full depreciation is allowed if an asset is used for more than 180 days in a year. If it is used for less than 180 days, the depreciation is restricted to 50%

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Book Profit and Taxable Profit

• Firms have to provide for depreciation in their financial statements as per schedule 14 of companies act using either SLM or WDV method

• But their taxable income is calculated as per the rates given by the Income tax act using WDV method

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MAT and deferred tax

• Companies are now required to pay 18% minimum alternate tax on their book profits even if their taxable income is nil (thus many firms have shifted from SLM to WDV)

• Using WDV method, firms defer taxes. Accounting Standards now require the company to disclose deferred tax liability and make provision for them in P/L

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Consistency Principle

• Change of depreciation method can be done only – When required by some law– When required by some accounting standard– When change results in more appropriate presentation e.g.

switch from SLM to WDV after introduction of MAT

• Consistency principle not violated– Different methods used for different type of assets– Different methods used for similar assets acquired at different

dates– Different methods used for similar assets located in geographical

different regions

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Depreciation for revalued assets• What if the asset is revalued during its usage• How do you treat the excess depreciation that should have been charged

but has not been charged

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Additional Depreciation charged to revaluation reserve

instead of P/L

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Disposal of Fixed assets

Fixed asset at historical cost/revalued amount

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Disclosures in F/S

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IFRS Converged IND AS 16 v/s AS-6

• Converged IND AS 16 requires the residual value and useful value to be reviewed at least at each financial year-end

• Converged IND AS 16 requires that the depreciation method applied to be reviewed at least at each financial year-end

• Converged IND AS 16 requires that the change in depreciation method be treated as a change in accounting estimate and not accounting policy (i.e. it should not be applied retrospectively)