Role of depreciation in financial statements - Finance Ppl

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Role of depreciation in financial statements

In this article, we shall discuss about depreciation and its impact on financial statements.

Definition of concepts of relevant to Depreciation :

In this section, we shall discuss the definition of various concepts relating to depreciation.

  1. Depreciation: Depreciation is the systematic allocation of depreciable amount of an asset, over its useful life.
  2. Depreciable amount: Depreciable amount is the cost of an asset or other amount substituted for cost (applicable when obtained in exchange or in kind) less its estimated residual value.
  3. Useful life: Useful life refers to a company’s estimate of period over which an asset is expected to be available for use in its operations. The asset’s useful life to the company can be lesser than its physical life.
    How?Useful life is a prudent accounting estimate made by the company considering the effect of asset’s usage pattern (shifts) and company policy.
  4. Economic life: Economic life is a broader concept. It refers to how long the asset can be of profitable use to anyone. Needn’t necessarily its first buyer.
    It is very much possible that the asset is of economic relevance to more than one user, due to resale or transfer.
  5. Physical life: How long the asset can physically function. Physical life can even be longer than the economic or useful life. But what is relevant for allocating depreciation is the useful life of the asset.
Depreciation methods:

Two most commonly used depreciation methods by companies are: SLM and WDV.

  1. WDV: Higher depreciation charge in earlier years and lower expenses in later years ( since WDV is on reduced book value each year). preferred by businesses seeking to minimize their tax burden in the initial years of an asset's life.
  2. SLM: Even charge across useful life of asset. Simple to calculate.

Under the Companies Act, 2013, both SLM and WDV are permitted. However, WDV is more commonly used by Indian companies, since WDV has the double advantage of being mandated by income tax also for tax purposes.
Companies can use SLM for one class of assets and WDV for another. Schedule II does not mandate a single method across all assets.

Schedule II as a guideline

Schedule II provides estimated useful lives for various tangible assets, serving as a general standard (Reference) for depreciation calculation. Tabulated below an extract from schedule II for some key assets :

Asset Useful life (In years)
Factory buildings 30 years.
Buildings (other than factory buildings) in RCC Frame Structure: 60 years.
Buildings (other than factory buildings) other than RCC Frame Structure: 30 years
Plant & Machinery (general): 15 years
Plant & Machinery (continuous process plant): 25 years
Motor vehicles (Bus, Car, lorries): 8 years
Motor vehicles (Two wheeler): 10 years
Electrically operated vehicles: 8 years
Carrier ships and liners: 25 years
Furniture & Fittings: 10 years
Electrical installations & equipments: 10 years
General laboratory equipment: 10 years
Office equipment: 5 years
Computers: 3 years
Servers &network: 6 years
Deviation from Schedule II:

The estimate of useful life of an asset shall not be different from the useful life specified in Schedule II. But, where a company adopts a different useful life, the financial statements shall disclose the details along with justification and supporting technical advice.

  1. Specially notified rates: where Specific useful lives are notified by a Regulatory Authority or the Central Government, then it shall take precedence over Schedule II rates.
  2. Extra shift depreciation: Schedule II's useful lives are based on single-shift working. Extra shifts (double or triple) require proportionate increases in depreciation, except for "NESD" assets, for which the depreciation rate remains the same regardless of how many shifts it operates.
  3. Life of child asset(component accounting): Significant parts of an asset with different useful lives should be depreciated separately.
Residual value:

The residual value of an asset shall not be more than 5% of the original cost of the asset. (Schedule II Part-C) Where company uses a residual value different from the limit above, FS shall disclose the details along with justification and supporting technical advice.

Depreciation rate for WDV based on useful life:

There is a formula for calculation of depreciation rate for WDV method, based on the schedule II useful life. The Formula is as follows:
Rate of Depreciation (R) = 1 – [S/C]1/n
Where,
S = Scrap value at the end of period 'n'
C = Written down value at present and
n = Useful life of the assets

Take an example where Cost of an Asset is Rs. 10 Lakhs with Estimated scrap value being Rs. 2.5 Lakhs and estimated useful life of the asset being 10 years. Given the company's plan to charge depreciation under written down value method, In order to calculate WDV % for the asset, following are the steps:

First step is: to calculate the part [S/C]1/n

  1. Divide salvage by cost (s/c) 2.5/10 = 0.25
  2. Substitute useful life of asset for n, which is 1/10 ie 0.1
  3. We are left with .250.1 for which we will find the result
  4. Now Using scientific calculator, this can be done: Type 0.25 (which is the base number), then press ^ symbol in calculator, then type the fractional exponent 0.1, Press the equals sign "=" This display the result, which is approximately 0.87055.

Second step is: Deducting the result of Step 1 from 1, which is 1 – 0.87055 = 0.12945

Third step is: Result of Step 2 x 100, which gives the depreciation %, Which in our case 12.95%

Depreciation's place in financial statement

The major role of depreciation is that it helps the entity plan for future replacements of assets.
How? The new acquisition is funded from the profit that’s retained and accumulated over the life of the existing asset in the form of depreciation charge.

  1. In Profit and Loss statement: Depreciation is recorded as expense and disclosed separately. Going by matching concept: For the revenue the asset generates, there must be a corresponding impact that should be given to P&L to represent the expense of running/using an asset.(wear and tear). Also, business can claim depreciation as a tax deduction, thereby reducing their taxable income. Depreciation is relevant for evaluation of financial ratios like operating margin and profit margin.
  2. Balance sheet: As far as balance sheet is concerned, carrying value of asset is its original cost adjusted for accumulated depreciation. This provides more realistic picture of asset’s worth as on the balance sheet.
  3. Cash flow statement: Depreciation is a non-cash expense and hence is added back to net income under the operating activities section, of the cash flow statement.