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Duration: 60

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Slides: 22

LMT SCHOOL OF MANAGEMENT, THAPAR


UNIVERSITY
Masters of Business Administration

Course: Financial Reporting and Analysis


Faculty: Dr. Sonia Garg (Email:
sonia.garg@thapar.edu)

Session 14: Depreciation of Fixed Assets

AS-6 weblink
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 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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Depreciation for Fixed Assets

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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Depreciation for Fixed Assets

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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Depreciation for Fixed Assets

SLM and WDV


SLM
Depreciation charge = (cost of asset
estimated residual value)/expected
useful life
WDV
Rate of Depreciation = 1 [(estimated
residual value/cost of
asset)^(1/expected useful life)]
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Depreciation for Fixed Assets

Problem on SLM and WDV

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SLM
solutio
n
Annual
depreciation is
uniform

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Depreciation for Fixed Assets

WDV
solution
Annual
depreciation is
declining
Same for SLM
and WDV

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Depreciation for Fixed Assets

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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Depreciation for Fixed Assets

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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13

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
Depreciation
for Fixed Assets
reserve instead
of

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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)
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