Policies related with Depreciation

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Depreciation Policy

Definition

Depreciation policy involves decisions related to the allocation and recording of the cost of tangible assets over their useful lives. It is crucial for accurately reflecting the value of assets and determining the financial performance of a business.

Key Elements of Depreciation Policy

  • Selection of Depreciation Method
    • Methods: There are several methods of depreciation such as Straight Line Method (SLM), Written Down Value Method (WDV), Sum of the Years' Digits Method, and Units of Production Method.
    • Selection Criteria: The chosen method should align with the nature of the asset, its usage, and how its economic benefits are consumed over time.
  • Review of Current Depreciation Provision
    • Assessment: Regularly evaluate whether there is an over or under provision for depreciation.
    • Adjustments: Make necessary adjustments to ensure the depreciation expense accurately reflects the asset's usage and value.
  • Evaluation from Tax Standpoint
    • Tax Implications: Assess the impact of depreciation methods on the company's tax liabilities.
    • Compliance: Ensure the chosen depreciation method complies with tax regulations and maximizes tax benefits.
  • Constitution of a Depreciation Policy Committee
    • Committee Role: Form a committee responsible for setting and reviewing the depreciation policy.
    • Responsibilities: The committee should oversee the application of depreciation methods, compliance with standards, and alignment with the company's financial strategy.
  • Proper Depreciation Amount and Recording Procedure
    • Calculation: Determine the accurate amount of depreciation for each asset.
    • Documentation: Establish a consistent recording procedure to ensure transparency and accuracy in financial reporting.
  • Disclosure in Annual Report
    • Transparency: Clearly disclose the depreciation policy in the company's annual report.
    • Stakeholder Information: Provide detailed information for the benefit of shareholders, investors, and other stakeholders.

Objectives of Depreciation Policy

  • Cost Recovery
    • Ensure the cost of fixed assets is recovered over their useful life.
  • Asset Replacement Fund
    • Create a fund for the future replacement of assets.
  • Tax Benefits
    • Take advantage of tax deductions available through depreciation.
  • Accurate Profit Determination
    • Determine the correct profit by accurately accounting for depreciation expense.
  • Uniform Rate of Return
    • Maintain a consistent return rate by aligning depreciation expense with the asset’s revenue-generating capability.
  • Working Capital Source
    • Sometimes use depreciation to create a source of funds for working capital.

Requirements of the Companies Act 1956 (Sec. 205 (2))

  • Provision of Depreciation Methods
    • Written Down Value (WDV) Method: Depreciation calculated at rates specified in Schedule XIV.
    • Straight Line Method (SLM): Depreciation calculated by dividing 95% of the asset’s original cost by its specified useful life.
    • Alternative Methods: Any other method with prior consent from the Central Government, ensuring 95% of the original cost is written off over the asset's useful life.
    • Non-Schedule XIV Assets: For assets not covered in Schedule XIV, rates are specified by the Central Government through general or special orders.
  • Schedule XIV Specifications
    • Provides separate rates of depreciation for WDV and SLM.
    • Specifies rates for single shift, double shift, and triple shift operations.
  • Asset Disposal
    • If an asset is sold, discarded, demolished, or destroyed before full depreciation, the difference between the book value and sale proceeds must be written off in the financial year in which the event occurs.

Conclusion

A well-defined depreciation policy is crucial for accurate financial reporting, tax compliance, and strategic financial planning. By selecting the appropriate method, regularly reviewing provisions, and disclosing the policy transparently, companies can ensure their financial statements reflect true asset values and provide meaningful insights to stakeholders.

AS-6 (Revised): Provisions and Reserves

Depreciable Amount Allocation

  • Systematic Basis: The depreciable amount of an asset should be allocated systematically over its useful life. This ensures that the cost of the asset is spread out to match the periods in which it generates revenue.
  • Consistency in Depreciation Method: The chosen depreciation method must be applied consistently from period to period, unless a change is mandated by statute or required for compliance with an accounting standard. Any change in method should reflect a more appropriate presentation of financial statements.
  • Change in Depreciation Method: If changing the depreciation method, the new method is applied prospectively from the date the asset was first used. Any surplus or deficiency arising from this change should be adjusted in the year the method is changed. Surpluses are credited to the profit and loss statement, while deficiencies are charged against it. This change is treated as a change in accounting policy and must be quantified and disclosed.

Estimation of Useful Life

  • Factors Considered: Useful life estimation considers expected physical wear and tear, obsolescence, and legal limitations on asset use. Periodic reviews may revise estimated useful lives, necessitating adjustments to depreciation charges.
  • Additions and Extensions: Additions integrated into existing assets are depreciated over the remaining useful life of the original asset. If additions retain separate identities and can be used independently after the original asset is disposed of, they are depreciated based on their own useful life estimates.
  • Adjustments to Historical Cost: Changes in historical cost due to exchange rate fluctuations, price adjustments, or similar factors require prospective adjustments to depreciation over the remaining useful life of the asset.

Revaluation of Assets

  • Revaluation Basis: Revalued assets have depreciation calculated based on the revalued amount and revised estimates of their useful lives. Material effects of revaluation on depreciation should be disclosed separately in the year of revaluation.

Disposal of Assets

  • Surplus or Deficiency: Upon disposal, any surplus or deficiency from the net book value of the disposed asset should be disclosed separately if material.

Disclosure Requirements

  • Financial Statements: Disclosure includes historical costs or substituted amounts, total depreciation for each asset class, and accumulated depreciation related to each class.
  • Depreciation Methods and Rates: Financial statements must disclose the depreciation methods used and any deviations from statutory rates or useful lives prescribed by law.

Conclusion

AS-6 (Revised) provides comprehensive guidelines for determining depreciation policies and practices, ensuring consistency and transparency in financial reporting. By addressing changes in methods, useful life reviews, asset additions, revaluations, and disposal impacts, the standard aims to enhance the reliability and comparability of financial statements across enterprises. Proper adherence to AS-6 (Revised) helps stakeholders understand the true economic impact of depreciation on an organization's financial health.