What are various methods of depreciation, advantages, disadvantages and revaluation of assets?

(This article explains various methods of Depreciation such as the Straight Line Method, Diminishing Balance or Written Down Value (WDV), Unit of production method, MACRS method, group depreciation method, etc. Advantages and Disadvantages of Straight Line Method, Advantages and Disadvantages of Written Down Value Method, Units of Production Method, Sum of the Years’ Digits Method, Amortisation of intangible assets.)

Depreciation means writing off the value of an asset over some time due to wear and tear, age, and obsolesces. There are three major methods of charging depreciation or recognition of the cost of the expiration of the cost of fixed assets viz. ‘straight-line method’, ‘written down value method’ and ‘Sum of the year’s digit method”. These different methods of depreciation are applied to fixed assets based on the plan that how the cost should be treated as expiring over the life of the assets. Depreciation is a major issue in the calculation of a company’s cash flows, because it is included in the calculation of net income, but does not involve any cash flow. Since depreciation is a non-cash transaction, a cash flow analysis requires the inclusion of net income with an add-back for any depreciation recognized as expenses during the period.

The straight-line method divides the depreciable amount of an asset by the estimated number of years to its useful life. The advantage of the straight-line method is easy to understand and calculate. It provides a consistent expense over time, which can help with budgeting and financial planning. The straight-line method is most useful when an asset’s value decreases steadily over time at around the same rate.  The disadvantage of this method is it does not reflect the actual value of the asset as the value of assets may not evenly decline. Assets might lose value more rapidly at the start or end of their useful life. May overstate depreciation expenses in early years and understate in later years. The straight-line method ignores variations in an asset’s usage, which can affect its value.

In the Written down value method of depreciation, the depreciation is charged at a certain rate and it is applied to the residual value of the assets (the value of the asset after the application of depreciation in the previous year). The Written down method is also known as the Reducing Balance Method. In the case of the ‘Sum of the year’s digit method’, the number of useful years of life left in the asset (is taken as a numerator) is divided by the sum of the digits of numbers of years of useful life. Let us take an example to understand this method. Let us presume the original cost of an item is Rs.15000.00 and the useful life of that item is 3 years. In this case, the sum of the digit of the useful is 3+2+1=6. Under the Sum of the years’ digit method, the first year’s depreciation will be charged at 3÷6×15000 =7500 Hence depreciation charged is Rs.7500.00 multiplied by the original cost of the asset, and in the second year depreciation is charged at 2÷6×15000=5000 multiplied to the original value of the asset, and finally in the last year depreciation is charged at 1÷6×15000=2500. You may observe that at the end of the third year, the book value of the asset after depreciation becomes nil. In other words, the accumulated depreciation at the end of the predetermined useful life of the asset becomes equivalent to the original cost of the asset. In some cases, companies might not have provided for depreciation as per statutory requirements due to strain in profit and therefore show it as arrears of depreciation in the notes to the balance sheet. The bankers normally indicate the arrears of depreciation using a footnote to the analysis.

Unit of production method:

The unit of production method is a method of calculating depreciation that is based on the actual use or production of an asset each period. It is used when the physical output of an asset is the primary factor in its decline, rather than obsolescence.

The formula for calculating depreciation using the units of production method is:

Units of production depreciation = [(Original value – Salvage value) / Estimated units produced over asset’s lifetime] x Actual units made per accounting period

Another method of calculation of depreciation is MACRS (Modified Accelerated Cost Recovery System), a tax-based depreciation method used in the U.S. that accelerates depreciation over a specified recovery period. It uses predefined depreciation rates for different classes of assets. The Group Depreciation method is used by some entities all as a single asset for depreciation purposes, simplifying calculations for similar assets acquired at the same time.

Why land- value is not depreciated?
Land value, generally will not come down, therefore land value is not depreciated. However, the leasehold land is depreciated for the lease.
The difference between depreciation and amortization: Intangible assets like patent rights, distribution rights, franchise rights, and copyrights have limited useful life. The process of exhausting the value of intangible assets in the same way depreciation is charged is called amortisation (to know more read: amortization schedule). The depreciation applies only to tangible assets.

Advantages of WDV: The WDV method calculates the current value of an asset by subtracting the accumulated depreciation from its original value. The WDV is used for taxation purposes.

The disadvantages of WDV: Calculating WDV can be time-consuming as it requires detailed records of asset usage and depreciation. The WDV method may not be suitable for assets that do not lose their value over time. The WDV method may not correctly evaluate assets that have uniform use for most of their lifespan because of the higher depreciation value in the early years.

Revaluation of assets:

In case the depreciable assets are revalued, the provision for depreciation is based on the revalued amount on the estimate of the remaining useful life of such assets. In case the revaluation has a material effect on the amount of depreciation, the same is disclosed separately in the year in which the revaluation is carried out.

The Securities and Exchange Board of India (SEBI) oversees the development and distribution of revaluation reserves. Revaluation reserves are a part of a company’s general reserves and are accessible for shareholder distribution under Indian GAAP.

Income Tax Act of 1961

The gain from revaluing assets is considered a capital receipt and is not taxed unless it is realized. If the surplus is issued as a dividend, it is subject to a dividend distribution tax.

Revaluation of property, plant, and equipment:

According to the Indian Accounting Standard (Ind AS) 16, revaluations should be made regularly to ensure that the carrying amount does not differ materially from the fair value at the end of the reporting period.

Revaluation of intangible assets

According to the Ind AS 38, the frequency of revaluations depends on the volatility of the fair values of the intangible assets being revalued.

Some methods for revaluing assets include Indexation, Current Market Price (CMP), Appraisal method, and Selective revaluation.

Originally posted on 25.09.2016 edited on 19.11.2024Related Posts:

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