ACCOUNTING AT THE TIME OF USE OF ASSETS: DEPRECIATION

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1 ACCOUNTING AT THE TIME OF USE OF ASSETS: DEPRECIATION When the assets are put to use, a portion of the cost is charged against the income for the period. Such charge is called depreciation. According to the matching concept, while determining profit for a period, revenue should be compared with the corresponding expenses. Profit = Sales COGS Operating Expenses Depreciation Amortisation Interest Tax Depreciation depends on the nature of the business. In some cases the depreciation may account for high percentage of sales. Table shows depreciation as percentage of sales of some of well known Indian companies: Table Depreciation as % of Total Sales as on 31st March 2006 Tata Consultancy Services Reliance Communications Ltd. 30% Ltd. 2.30% Bharti Airtel Ltd. 14% I T C Ltd. 2.00% Oil & Natural Gas Corpn. Ltd. 14% Maruti Udyog Ltd. 1.90% Mahanagar Telephone Nigam Ltd. 12% Hindustan Lever Ltd. 1.00% Videsh Sanchar Nigam Ltd. 9% Siemens Ltd. 1.00% Meaning of Depreciation According to the Accounting Standard (AS)-6, Depreciation 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 is allocated so as to charge a fair proportion of the depreciable amount in each accounting period during the expected useful life of the asset. Thus depreciation can be explained in following ways: Cost of the asset apportioned over the life Charge for using the assets Provision for replacement of assets Loss due to the wear and tear of assets 13 Ramana, XIMB 13

2 Only depreciable assets can be depreciated. According to AS-6 depreciable assets are assets which are expected to be used during more than one accounting period; have a limited useful life; and 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. Depreciation is charged over the useful life of the asset. Useful life, according to the AS-6, is pre-determined by legal or contractual limits, such as the expiry dates of related leases; directly governed by extraction or consumption; dependent on the extent of use and physical deterioration on account of wear and tear which again depends on operational factors, such as, the number of shifts for which the asset is to be used, repair and maintenance policy of the enterprise etc.; and reduced by obsolescence arising from such factors as: (a) technological changes; (b) improvement in production methods; (c) change in market demand for the product or service output of the asset; (d) legal or other restrictions. Depreciation and Financial Statements As mentioned in the previous sections, depreciation is allocation of cost or a charge for using the fixed asset. So while determining the profit for a period depreciation is required to be deducted from the income along with other expenses. However, depreciation does not involve any outflow of cash. Let take the following example to understand the impact of depreciation on the financial statements. 14 Ramana, XIMB 14

3 Example11.8 Table shows balance sheet shows the assets and sources of A ltd. Table Balance Sheet as on 1 st April 2005 Sources Assets Capital Cash % Loan Stock Creditors A ltd purchased Plant (life 5 years) costing Rs. 80,000 for cash. During the period of one year sold entire stock for 50,000. T Table Cash Flow Statement Receipts Opening Cash 100,000 Sales 50, ,000 Payments Plant 80,000 interest 6,000 CIH 64, ,000 Table Income Statement Incomes sales 50,000 Expenses COGS 25,000 Depreciation 16,000 Interest 6,000 Profit 3,000 50,000 Table Balance Sheet Source Capital 50,000 12% Loan 50,000 Profit 3,000 Creditors 25, ,000 Cash 64,000 Plant 64, , Ramana, XIMB 15

4 Summary of the impact of the above transactions on the financial statements is given below: Cash Flow Statement Cash outflow : o Purchase of plant: 80,000 o Payment of interest: 6,000 Cash inflow: Sale of goods for 50,000 Income Statement Income: Sale of stock for 50,000 Expenses: o COGS: 25,000 o Depreciation = 16,000 o Interest = 6,000 Balance Sheet Plant will reduce by the amount of depreciation Stock will reduce to the extent of Rest Cash will increase to t he extent of sale Profit will appear as a source Depreciation can be shown in the balance sheet in two different ways as follows: Assets are shown at the net value (cost less depreciation): As shown above Assets are shown at the gross value (at cost) and depreciation is shown as accumulated amount Table Balance Sheet Capital 50,000 12% Loan 50,000 Profit 3,000 Creditors 25, ,000 Cash 64,000 Plant Less Accumulated Depreciation 16,000 Net Fixed Assets 64, ,000 In this case the assets are always shown at the original cost. Depreciation for the year is added to the accumulated depreciation. Depreciation for the period is shown in the income statement and the balance sheet shows the depreciation upto the period. 16 Ramana, XIMB 16

5 Disclosure of Information in the Financial Statements The following information should be disclosed in the financial statements: the historical cost or other amount substituted for historical cost of each class of depreciable assets; total depreciation for the period for each class of assets; and the related accumulated depreciation. The following information should also be disclosed in the financial statements along with the disclosure of other accounting policies: depreciation methods used; and depreciation rates or the useful lives of the assets, if they are different from the principal rates specified in the statute governing the enterprise. Methods Of Calculating Depreciation Now let us see how is depreciation calculated? There are several methods of allocating depreciation over the useful life of the assets. Those most commonly employed in industrial and commercial enterprises are the straight line method (SLM) and the reducing balance method (RBM). Though AS-6 mentioned SLM and RBM, depreciation can be determined calculated in one of the following methods: Straight Line Method (SLM) Reducing Balance Method (RBM) Double Declining Method (DDM) Sum of Digits Methods (SDM) Sinking Fund Method (SFM) Straight Line Method (SLM) Straight-line depreciation spreads the depreciable value evenly over the useful life of an asset. It is the most common method of depreciation. Depreciation is calculated as follows: Depreciation = Acquisition cost Residual value Years of useful life In this case depreciation is calculated as percentage of the original cost (after deducting the residual value). 17 Ramana, XIMB 17

6 Reducing Balance Method (RBM) As the name suggests, depreciation is calculated on the written down value (WDV) of the asset. Written down value of the assets is cost of the assets less depreciation. Since WDV of the asset goes on reducing, depreciation calculated on this basis will also reduce over the year. Example:11.9 Let take an example to understand SLM and RBM. A ltd purchased plant costing Rs. 50,000; Depreciation rate for SLM = 10% and for RBM =20%. Depreciation schedule will be as follows: Table Depreciation Methods Cost of the assets 50,000 Method SLM RBM Year Dep WDV Dep WDV 1 5,000 45,000 10,000 40, ,000 40,000 8,000 32, ,000 35,000 6,400 25, ,000 30,000 5,120 20, ,000 25,000 4,096 16,384 Depreciation under SLM = Cost * Rate = 50,000 *10% = 5,000 Depreciation under RBM o First year = 20% of 50,000 (Cost) = 10,000 o Second year = 20% of 40,000 (WDV) = 8,000 o WDV= Written Down Value = Cost Depreciation Double Declining-Balance Depreciation (DBM) Double declining balance method is also one type of reducing balance method. Depreciation in the early days will be higher than the later years. DDB is computed as follows: Compute a rate by dividing the cost by the years of useful life. This result is the straight-line rate. Then double the rate. In the above example, the straight-line rate is 10%. The DDB rate would be 2 X 10%, or 20%. Sum of Digits Method Sum of digits method is also a type of reducing balance method. Depreciation under this method is calculated as follows: First Year : Depreciation = Cost * Remaining Life/Sum of digits of total life Subsequent years = WDV * Remaining Life/Sum of digits of total life 18 Ramana, XIMB 18

7 Example: Cost of the asset = 50,000; Life of the asset = 5 years Sum of digit = = 15 Depreciation First year 50,000 * 5/15 = 16,667 2 nd Year = 50,000 * 4/15 = 13,333 3rd Year = 50,000 * 3/15 = 10,000 4 th Year = 50,000 * 2/15 = 6,777 5 th Year = 50,000 * 1/15 = 3,333 Table Sum of Digits Method Year Cost Depreciation WDV 1 50,000 16,667 33, ,333 20, ,000 10, ,667 3, ,333 0 In this method also, the amount of depreciation goes on reducing over the life. High depreciation is charged in the early life of the asset. Change in Depreciation Method Companies are allowed to change the method of depreciation. A company using SLM can change to RBM. Such change can be made from the first date of use. According to the AS-6, a change from one method of providing depreciation to another is made only if the adoption of the new method is required by statute or for compliance with an accounting standard or if it is considered that the change would result in a more appropriate preparation or presentation of the financial statements of the enterprise. When such change is made, deficit or surplus should be charged to income statement as profit or loss due to the change in the methods of depreciation. Steps involved in doing the necessary adjustments are as follows: Find total depreciation charged using the present method of depreciation; Find total depreciation to be charged using the new method of depreciation; Find the difference in the depreciation charged and depreciation to be charged; Transfer the difference to the income statement as profit or loss; 19 Ramana, XIMB 19

8 Example Let us take an example to understand the change in the method of depreciation. In 2002 (April) A ltd. raised capital of Rs. 50,000 and a 12% loan of Rs.100,000; Used 50% in acquiring a plant and balance for acquiring stock. Charged depreciation using SLM at 10%. In the year 2006 (April) changed the depreciation to RBM (20%). Sales in 2006 = 80,000; COGS and other expenses (other than depreciation) = 30,000; Show the impact on the financial statements. First calculate the depreciation under both methods. Table shows such calculation. Table Change in Depreciation Methods Cost of the asset 75,000 Method SLM RBM 1st April Dep WDV Dep WDV ,500 67,500 15,000 60, ,500 60,000 12,000 48, ,500 52,500 9,600 38, ,500 45,000 7,680 30,720 Total 30,000 44,280 Total Depreciation under SLM = 30,000 Total Depreciation under RBM = 44,280 Find the excess of depreciation to be charged if the method is changed from SLM to RBM. Additional depreciation to be charged due to the change = 14,280 ( 44,280 30,000) Current depreciation = 20% * 30,720 = Rs. 6, Ramana, XIMB 20

9 Financial statements will be as follows: Table Balance Sheet as on 1st April 2006 Capital 50,000 Loan 100,000 Profit 0 150,000 Plant 75,000 Less Accumulated Depreciation 30,000 45,000 Cash 105, ,000 Table Income Statement Sales 80,000 Less Expenses 30,000 PBDIT 50,000 Extra Depreciation 14,280 Current Depreciation 6,144 PBIT 29,576 Interest 12,000 PBT 17,576 Tax 7,030 PAT 10,546 Table Balance Sheet as on 1 st April 2007 Capital 50,000 Loan 100,000 Profit 10,546 Plant 45,000 Less 160,546 Extra Depreciation 14,280 Current Depreciation 6,144 24,576 Table Cash Flow Statement Opening CIH 105,000 Sales 80,000 Less Expenses 30,000 Interest 12,000 Tax 7,030 Closing CIH 135,970 Cash 135, ,546 Accounting Real Life Reliance Industries Limited changed the method of depreciation from straight line method to written down value method with effect from , for Cracker and Aromatic plants at Hazira on account of technological advancements and obsolescence and for buildings, electrical installations, factory equipment, furniture and fixtures and vehicles, other than those situated at Jamnagar to provide for timely replacement. 21 Ramana, XIMB 21

10 Consequent to this, there is an additional charge for depreciation during the year of Rs Crores due to the said change which relates to the previous years and an equivalent amount has been withdrawn from General Reserve and credited to the Profit & Loss Account. Had there been no change in the method of depreciation, the charge for the year would have been lower by Rs Crores, excluding the charge relating to the previous years. Consequently, the Net Block of Fixed Assets and Reserves and Surplus are lower by Rs Crores. RIL Notes on Accounts 01 During the year, the company has changed its accounting policy with regard to its computers and office equipment. Hitherto, depreciation has been charged under straight line method applying the rates given in schedule - XIV to the companies Act, Now, it has been changed to charging depreciation based on the useful life of the said assets. Accordingly, the depreciation has been recalculated from the year of it's acquisition and the resultant extra depreciation a mounting to Rs mm has been charged to Profit and Loss account. Consequent to the change in the accounting policy, the profits for the year, the net depreciated value of the fixed assets and the reserves and surplus have been understated by the said amount, compared to the earlier policy followed by the company. Amarraj Bat 2006 Change in cost of assets Cost of the asset is the money paid to acquire it and the incidental expenses. According to AS-6, the historical cost of a depreciable asset may undergo subsequent changes arising as a result of increase or decrease in long term liability on account of exchange fluctuations, price adjustments, changes in duties or similar factors, depreciation to provided on the revised un-depreciated cost over the residual useful life of the asset. Depreciation: Income Tax and Shareholder Reporting Accounting and reporting for fixed assets to stock holders and to the income tax authorities often differ. Reports to stockholders must abide by generally accepted accounting principles (GAAP). In contrast, reports to income tax authorities must abide by the income tax rules and regulations of the Income Tax Act Therefore, keeping two sets of records is neither immoral nor unethical. For example, the Companies Act 1956, allows any method of depreciation, whereas, the Income Act 1961 provides depreciation under reducing balancing method. 22 Ramana, XIMB 22