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Methods of Providing Depreciation

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Namaste.If you remember in the last session, we had started our discussion on the concept of conservatism.Can somebody tell what is conservatism very briefly?By conservatism what we mean is, any possible loss we need to provide for; possible I amsaying not certain even if there is a chance of a loss, we should provide.But if there is a possible game, but it is not certain then we will not account for it.So, accountants follow a very prudent path or a conservative path and normally assigna lower value when two values are available.We had seen two examples of this.One is because of the application of the concept of conservatism; the closing stock is to bevalued at cost or market value whichever is lower.The second one was depreciation is required to be provided every year.Now, most of you would have read your annual report.Just look at the financial statements.After the financial statement, in the note number 1 company would have given importantaccounting policies.Please go through those accounting policies.Several of those accounting policies are based on the concept of conservatism.Please try to identify them.We have just given two examples of valuation of stock and depreciation, but some more examplesyou can find if you read carefully ok.So, let us go ahead with today's session.Then in the last session, we had started discussion on depreciation.First of all how do you define depreciation?See depreciation is a loss in value as the name suggest, but it is a continuous and gradualloss in value of fixed assets.In case of other assets like inventory or like investment, values can go up and down.But for fixed asset from the date of purchase, till the date it is scrapped out the valueof asset continuously falls and that fall is what is known as depreciation.So, it is a gradual and continuous fall in the value of asset mainly because of fourreasons.Do you remember those four reasons?I think most of you are remembering.So, lapse of time, wear and tear, obsolescence and exhaustion.Particularly the first three are important for most of the assets and exhaustion; thefourth one is for which asset?It is only for assets like a mine ok.Now, we went into the discussion on the methods of depreciation.Now to calculate any depreciation, we need three important estimates.First one is mostly actual that is a cost of asset, then estimate of the useful lifeand the estimate of the scrap value.Based on these three we try to calculate annual depreciation for each and every tangible andintangible asset.Now, to calculate them, there are four methods there are several methods, but four methodswe are going to discuss in these this.The first two are very important; the straight line and reducing balance.Last time we had discussed straight line.Do you remember what is straight line method?.I will just give you a very simple example.Suppose we have purchased one asset say, machinery for 1 lakh.It is useful life is 4 years, scrap value is let us say 10000.What will be the depreciation every year?1 lakh minus 10000; that means, 90000 is to be distributed over a period of 4 years.So, we will simply divide 90 by 4.So, 90000 upon 4 is a depreciation per annum.Getting it?So, it will be 22500 and this is known as straight line method.You can see the formula ok; cost of asset minus scrap value upon useful life.Now, what will happens due to this is the depreciation remains constant throughout theuseful life.The second method is known as reducing balance method.Now in reducing balance method what happens is instead of annual depreciation which isfixed, we calculate a we arrived at a depreciation rate.So, suppose the same machine; let us say is having a value of 1 lakh in the beginning.And, suppose the rate of depreciation is taken as 25 percent, then in year 1; it will be1 lakh into 25percent that is 25000.In year 2, we will not apply 25000 on 1 lakh.We will take 1 lakh minus the first year’s depreciation that is 25000.So, 75000; the 75000 is known as written down value.See acquisition cost minus depreciation.Now on 75000, 75000 into 25 percent is a second years depreciation; in third year it is 75minus the second years depreciation that is 22500 and so, we will get a further reducedvalue, on that we will charge the same rate that is 25 percent.So, effectively the amount of depreciation will go on reducing every year that is whyit is known as reducing balance method.Last time we had stopped our discussion with the comparison of the two methods; straightline and reducing.Now, between the two methods, which method is better in your opinion?I think those who like simplicity, we will say that straight line is simple.So, it is good.There are some advantages of straight line, but there are a lot of advantages with reducingbalance Now in reducing balance, what happens is the value of depreciation falls over aperiod of its useful life.In the earlier year, the depreciation is higher; in the later year, the depreciation is lesser.Now, this is a very good thing because every year the cost of repair is likely to increasebecause the machine is becoming older.So, it is good to charge more depreciation in the initial years and lesser depreciationin the later years.Because initial years repair will be less, but depreciation is high; later year let usskip depreciation less.So, that repair more of repair can be born that is one approach, that is also anotheradvantage is reducing balance.Because in the initial year there is significant loss in the value that gets better reflectedin the balance sheet; if we charge more depreciation in the earlier years which happens in reducingbalance.That is why income tax act allows only one method that is reducing balance method incompanies act both the methods are allowed; straight line as well as reducing balance.If you are reading the balance sheet of your company which you have chosen, please readtheir depreciation schedule.In the depreciation schedule, then we have mention the method as well as the rate atwhich they are charging depreciation.I hope you getting it.Now let us go.So, this is a formula once again you can have a look at it.Last time we had done these calculations.Now, let us go to the third method that is known as machine hour method.Now what happens is in case of certain machines, the life depends on how many hours you usethe machine.So, the depreciation is also calculated as per the likely life which is calculated interms of its working hours.So, this is an example.If the cost of machine is 5 lakhs and estimated working hours are 40000 scrap value is 10000.Now, there given the pattern of effective working hours.Let us say in year 1-2, it is 5000; 3-5 it 7000 and 6-7, it is 3000.Now how do you compute depreciation?Now, what we will do is we know the cost and we also know that the estimated working hoursare 40000; scrap value is 10000; so, instead of charging straight line depreciation whichwill be uniform or instead of charging depreciation at a certain rate.We will calculate it on per hour basis and then based on the hours in that particularyear, we will compute the depreciation.For example, firstly, we will we know that the total depreciation total number of workinghours are 40000.Now the cost of machine is 5 lakhs minus 10000; that means, basically we have to depreciate490000 over its useful life.In year 1 and 2, it is a new machine yet to settle.So, useful hours or useful hours are only 5000; so, 5000 upon 40000 into 490000.So, the cost is the depreciation is 61250 in year 1 and 2.Are you getting?Now, in year 3, 3 to 5; now the amount to be depreciated is same 5 lakh minus 10000that is 490000.In year 3 to 5, the estimated number of hours are 7000.So, 7000 divided by the total hour that is 40000.So, each year we are getting 85750 as depreciation from year 3 to 5, fine.And for year 6 to 8, now the machine as rather become older.So, the useful hours per year are only 3000; so, 3000 upon 40000 in to 5 lakh minus 10000which is constant.So, in year 6 to 8, the annual depreciation is only 36750.Are you getting?So, here instead of reducing it over a period, we are going by its utilization.So, in a year how many hours you use, accordingly the depreciation is charged.Are you getting?This is known as machine hour method and fourth one which we are going to discuss is productionunit method.Now, in production unit method, what we are doing is we are looking at the annual productionand the depreciation will be charged based on the production in that year.Now, this is the formula we use.So, what we do is, total depreciable amount will be divided by the estimated total production.Out of the total production whatever is a production units for that particular periodthat much portion will be depreciated in that period.Let us check this example.So, cost is 30000, estimated total production is 4000; it is in terms of unit, the scrapvalue is 2000.So, basically you will see that 30 minus 2; that means, 28000 is a depreciable amountwhich is mainly for the production of 4000.Now, this 4000 is spread over three years in this manner.In year 1, estimated is 2000, year 2, 1500 and year 3, 500.So, what we will do is the depreciation is for 4000 units, we will spread it over asper the estimates of units.So, in year 1, 30 minus 2 that is 28000 is to be basically depreciated and here we take2000 divided by 4000; that means, for year 1, the depreciation is estimated to be 14000.In year 2, the formula is same it is 1500 upon 4000; that means, we are calculatingit based on 10000; we are calculating it to be 10500.Now can you do it year 3?Just have a look once again.So, 30 minus 2; that means, basically 28000 upon 4000 and in year 3, the estimated unitsare just 500.So, you can do it orally also; 500 into 28000 divided by 4000.Are you getting it?This is the calculation.So, you are getting 3500 per year.Are you getting?There are some more methods, but they do not have much of practical utility.The first two methods that is straight line and reducing balance are the most importantmethods and almost all companies use any one of the two, particularly the second methodthat is reducing balance is most important.Most of the companies using and as per income tax act, it is mandatory to use reducing balancemethod.The third and fourth method are not use normal in financial accounting, but they will beuseful for managerial or for cost accounting.That is why, I have covered it in this particular session ok.So, with this our discussion on depreciation is over.I will once again remind you to look at the depreciation schedule as per your own companyand that will give you some more inputs.So, with this now having discussed about depreciation, let us have a look at how it appears in theannual report.I have been telling you in every session that you decide a company, go to the annual reportof that company and as we discuss have a look at the statements which are as published bya particular company.Now, here I am showing you extracts from Tata motors annual report so, that you will actuallyhave a feel of how it looks like.So, right now, we are in the section of balance sheet; within balance sheet, you can havea look at assets.I hope it is visible; though the font is little small, but this is how actually it is in theannual report of Tata motors.So, you can see item a is property plant and equipment.This is something which we were discussing about when we were discussing depreciation.Over all within noncurrent assets, a list of asset is provided and then the descriptionof each asset is given.So, property plant and equipment is described.Now, in the end if you look there is a table which is showing the type of the asset andestimated useful life.I think this is very interesting because for calculation of depreciation, we have seenwe want to estimate useful life of a particular asset and that will be the basis for calculationof depreciation.So, here you can see the types, building, then roads, bridges and culverts.For that the life is reasonably wrong.So, it is 4 to 6 years.Then plant machinery equipment, it is 3 to 30 years.Computers and it related assets is 3 to 6 years, vehicles 3 to 11 years, furniture fixtures3 to 21 years.So, reasonably long range, but for a particular class of assets, they have defined some estimateduseful life Now for a particular asset within that range, they would decide the useful life.Now, next they have given definitions of some of the terms like depreciation, then the termsin the box have also been defined like accumulated depreciation.So, I hope you remember, what is depreciation.This is a loss or reduction in the value of asset in a particular year.Now for that asset, the depreciation for year 1 is say 10000; year 2, 8000; year 3, 4000;then what we do is we accumulate or collect the depreciation.So, in year 1, it will be 10, in year 2, it will be 10 plus 8, 18; in year 3, it willbe ten 8 and 4, 22.Like that the total depreciation or accumulated depreciation is calculated and it is to bedisclosed in the balance sheet.After that, there is a item called as depreciation expense.Depreciation expense refers to the depreciation for that particular year and the last itemgiven over here is salvage value; salvage value or scrap value.This is at the time of disposal, what value you have is called as a salvage value ok.Now this is a very important.Note: I know it is little difficult to read, but I have given it here because as it isas what is in the annual report.So, it starts with the assets which are owned by the company.So, it says owned assets, then the category of assets are given starting with land, building,then plant and equipment, furniture and fixtures and so on.Now, the cost as at April 1, 2016 that is the opening balances are given, then additions,then currency translation differences, then disposal.Now the total of all this will be the cost as on March thirty first, 2017; that is theclosing cost.So, just to give the cost of the asset; the original cost, there are four items disposalwill of course, be reduced, but the total will be the cost at the end.Now the next is accumulated depreciation as on April first 2016.So, at the beginning of the year, what is the depreciation than the depreciation whichis added, depreciation which is written off, the depreciation on disposal.Then at the end, you are got accumulated depreciation as at the end of the year.So, we considered all the cost, then all the accumulated depreciation cost minus accumulateddepreciation is a net carrying amount.We were discussing about WDV written down value.It is same as the net carrying account amount has been discussed.Now, a few more things; now this is related to intangible assets.Now this is about the goodwill.One of the important intangible assets is goodwill.Now, what happens is when company acquires other assets, it may pay more than what amountis a fair value of that asset.So, suppose you are acquiring assets worth 15 crore, but you are paying 18 crore letus say.So, you are paying 3 crore more 18 minus 15, 3 crore which you are paid will be consideredas goodwill.There is another category of goodwill which is known as self generated goodwill, but itis not disclosed in the balance sheet.What is disclosed in the balance sheet is called as a purchased goodwill which is classifiedas intangible asset in the balance sheet.So, here we are looking at a purchase goodwill.So, first the definition of goodwill is given and then the value of goodwill as is disclosedin the balance sheet, you can have a look.Under the assets non-current assets, there is items c called as goodwill ok.Now, if you go little ahead, there is a working table which is given in the for the goodwill.It is similar to that for a tangible asset, but slight different; first balance at thebeginning, then it is called as impairment.That means if asset loses its value, it is called as impairment.So, some amount is provided as impairment.There is currency translation differences because though that goodwill is in foreigncurrency and the balance at the end.You can just have a look at what is impairment.Now cash generating units to which goodwill is located are tested for impairment annually.So, what it means is, you have paid for certain amount as a goodwill assuming that that particularunit or that particular part of the business would be able to generate cash.If that business does not have that capacity any longer; that means, the depreciation isno longer applicable.In such cases, the depreciation is written off or its value is removed from the balancesheet that process is called as an impairment.Now, further we will go to other tangible assets.So, other intangible assets I am sorry.So, here in the assets after goodwill which you see item like other intangible assetsare given.I think, we are already discussed intangible asset.Intangible assets are those assets which you cannot touch or feel.Now these assets are also required to be amortized.So, they are to be depreciated, but here since they are intangible that is called as theyare to be amortized.Now you can see here type of the asset and estimated useful life.So, for patents, it is 2 to 12 years; for computer software, it is 1 to 8 years, thenfor dealer network, it is 20 years and for intellectual property rights, it is 3 to 10years.So, I hope you are getting the difference.For goodwill, there is no particular estimated useful life.It can remain perpetually, only thing is you test it for impairment.If that particular business or product has lost its value, then we will write off goodwill.We will call it as an impairment, but for other intangible assets, we will charge depreciationthat is known as amortization.The calculation is same like for depreciation.So, you will need an estimated life.So, that estimated life is given ok.Now there is one more working table again the font is small, but just you can have alook.It says working table for other intangible assets.So, just like for tangible assets, it starts with opening balances additions and so onand then accumulated depreciation is calculated and then you get the final value.There is one more exhibit a.These are excerpt from the annual report page 155.Now here, the final disclosure is given.So, property plant and equipment that is the tangible assets total and goodwill and otherintangible assets total which gives you the total of total ok.If this is not so, clearly visible I would request you to download the annual reportof Tata motors and see it yourself, I am sure you are also looking at annual report of yourown company.But, I am just showing you because when actually you see it, you will have the feel of it.Then some term boxes are given like amortization, expense and total accumulated amortization.This is just like depreciation; amortization expense refers to amortization during theyear and there is accumulated amortization just like accumulated depreciation.So, this was the actual extract of the annual report of Tata motors of 2016-2017 ok.Please have a look at it and I hope your, the concept of depreciation are more clearto you now.Namaste.