Depreciation-AS 6

Fixed assets are acquired with an intention to use for business operations, are generally in the nature of infrastructure and have a longer useful life. These have the following characteristics: Tangible assets which are held for use in business Acquired with an intention to use and not for sale Have a longer life; and Provide security for long term loans. Typical Problems Areas of Fixed Accounting 1. Acquisition Problem-Measurement of cost 2. Period holding & use (assets decline in economic value) a. Expenditure to maintain and /or improve b. Periodical revaluation: as a substitution of cost c. Depreciation: periodical reflection of part of assets consumed. 3. Recognition of gain or loss on disposal. Why Depreciation? Having discussed depreciation, let us now discuss why depreciation should be provided. Since the useful life of an asset is limited, depreciation arises due to; The physical process of wearing out, and Obsolescence, i.e., loss of usefulness because of development of an improved asset, or a change in style or other causes not related to the physical condition of the asset. So depreciation relates both to the use of the assets and time. It may ne noted that there is no depreciation for land, as its life is not limited, except in the case of agriculture land, whose fertility of the soil is limited and is thus subject to depreciation. Depreciation serves various purposes which include: Arriving at the cost of the product and quoting price on the basis of the costs. So depreciation is shown as an expense in income statement and is a charge on profit Showing the assets in the balance sheet at their true value. Accordingly (accumulated) depreciation is deducted, from the cost of the assets in the balance sheet, so as to reveal the true financial health of the organization. To work for the replacement and renewal of assets. Thus, depreciation may be stated to be a function of its costs, life, use, salvage value and maintenance. The life of an asset is not its engineering life or its operational life, but its useful economic life to the enterprise after considering the obsolescence factor. How much Depreciation?

How is depreciation determined? In the absence of any direct approach to determine depreciation by observing the amount of the assets physically consumed during the year, (as there is no physical indication of deterioration) we look for conceptual ways for looking at depreciation. Broadly there are two conceptual views regarding the depreciation process. These are as: Fixed assets provide service over its life, the service being equal in each year of its life. The same amount of depreciation is provided in each year of the assets life. In other words, depreciation is provided at a certain percentage (the rate is reciprocal of the estimated useful economic life), on the original costs of the assets. This method of depreciation is known as Straight Line method (SLM), Fixed assets are considered more valuable in their youth, than in their old age and their mechanical efficiency tends to decline with age. This concept takes a broader view of the assets, and considers that o Maintenance costs increase with age, and o Better equipment will be available which will make the existing one obsolete. The amount of depreciation, under this approach, is provided at a certain rate on the written down value (WDV) of the assets and as such the amount of depreciation is higher in early years and reduces over the years (WDV is the cost minus depreciation provided so far. This method of depreciation is called, WDM or Diminishing balance method. Depreciation Practices Of the various methods of depreciation, the SLM and the WDM are common among accompanies in India for reporting purposes. For determining the amount of depreciation, the rates of depreciation both for SLM and WDV methods for various kinds of assets have been prescribed by the Companies Act 1956 (as amended in 1988) and a company is free to follow any of these methods for the purposes of preparation of accounts. However, for income tax purpose, a company is required to provide depreciation by following the WDV method at rates so specified in the Income Tax rules. It is viewed that the rates of depreciation prescribed in the Companies Act are the minimum rates and a company is free to provide higher amount o depreciation, if its management considers it relevant. SLM and WDV methods have a different impact on the financial results reported in the profit and loss account and balance sheet. The depreciation amount is uniform throughout the life of the asset under SLM, while it decreases over the years under the WDV method. Under WDV, more than 50% of the asset cost is provided as depreciation in the first two years, while under SLM only one-third has been provided during the corresponding period. So, due to the higher amount of depreciation under WDV method in the first two years, the profit reported would be low, while for a company following SLM, the reported profits would be relatively higher and the assets value as shown in the balance sheet would also be higher.

Notes: Depreciation should be calculated and provided for in the P&L A/c, even if the asset remained idle during the year. If the asset has been used only for a part of the year, depreciation should be calculated only for that period. If the assets are used for double/multiple shifts, the depreciation is to be calculated for the actual use of the asset. Land and building are separate assets. AS-6 does not apply to land which is a nondepreciable asset, unless the land has a limited useful life for the enterprise. Change in value of the land does not affect the amount of depreciation on building built on the land. AS-6 does not give the rates of depreciation. The companies sin India are following the rates as given in the Schedule XIV as the minimum rates of depreciation. Higher rates may also be used. Depreciation should be charged even if the asset is kept in the best workable condition and /or its market value has gone up, because depreciation is charged as allocation of cost. Usually same method of depreciation is used for same group or class of asset. For different classes, different rates and methods can be used. Items costing below Rs 5000 each are generally written off in the year of purchase. AS-6 is not applicable to land, live-stock, mineral oils, plantation, forests, intangibles assets etc. Cost of leasehold land should be amortized over the lease period. Recalculation of depreciation o Change in historical cost: historical cost refers to the acquisition cost. The historical cost may also change subsequently on account of factors like; Change in duties Change in long-term liability on account o exchange fluctuations Price adjustments It may be noted here that the revised deprecation is to be applied PROSPECTIVELY. o Change in Useful Life of the asset: useful life, in certain cases, gets over prematurely due to factors such as: Technological changes Improvement in production methods; Legal or other restrictions In this case also, depreciation is to be calculated on the new amount PROSPECTIVELY. Revaluation: In case there is a revaluation of asset depreciation amount should change only for the period current year onwards. In this case also, depreciation is to be calculated on the revalued amount PROSPECTIVELY. In case, additional amount has been charged to accommodate the change of value of asset, equivalent amount may be transferred from the Revaluation reserve to current year P&L A/c, so that the current year profit remains unaffected. 3

o Change in Method: in the following circumstances, the method of depreciation may be changed: o When the adoption of the new method is required statue; o When it is considered that the change would result in a more appropriate preparation or presentation of the financial statements. o When the adoption is required for compliance with an Accounting Standard. In this case, the change should be applied with RESTROSPECTIVE EFFECT, i., the date when the asset was put to use. In case, additional depreciation has been charged to accommodate the change of method of depreciation with retrospective effect, equivalent amount may be transferred from the general reserve to current year P&L A/c, so that the current year profit remains unaffected. Inventory Valuation AS-2 Inventories should be valued at the lower of the cost or net realizable value. Net realizable value is the estimated selling price less the estimated cost necessary to make the sale. The cost of inventories includes all costs incurred in bringing the inventories to their present location and condition. The overheads costs are assigned based on normal capacity level. However, in case of high production, the overheads should be allocated on the basis of actual production. The cost of inventories is taken at FIFO or weighted average methods. Machinery spares held for use in fixed assets are not included in inventory. Interest and borrowing costs are not included in valuation of inventories. For buyer, the goods are transits are included in inventory, only if the risk and rewards of ownership have passed to him. If not, it is the inventory of the seller. Materials given on loan are not an inventory. Rather, it should be shown as Loans and advances.