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An Overview: Depreciation
Before diving deep into a change in the depreciation methods, it is essential to know about what depreciation actually is, its formula, and multiple methods of calculation.
What is meant by Depreciation?
The term “depreciation” refers to the annual depletion of assets due to usage or wear and tear, which is the loss that occurs as a result of not paying for them in future cash flows. There are two types of depreciation methods: straight-line and written down value methods.
Depreciation Method Formula
The following formula is a good example of how to go about calculating depreciation using a single-line method.
depreciation method (years) = cost of asset – salvage value/ useful life of asset (years constant, not inflation adjusted)
The formula is explained below and has been given a detailed explanation about what transpired in the whole process, read the following explanation:
The machinery is purchased at the market price of ₹20,000. It is to be realised at the end of its life span at ₹5000. The lifespan of the machinery is 5 years. calculate the depreciation charge of the machinery after 5years that is to be recorded by the company.
Cost of asset = ₹20,000
Salvage value = ₹5000
Lifespan = 5years
Depreciation = 20,000 – 5,000/ 5 = 3,000
₹3,000 is the depreciated value of machinery after 5 years of lifespan
Change in the Depreciation Methods
The concept of change in depreciation method is used by the companies at the time when there is a change in the future economic benefits which are derived by the company from a particular asset. According to Accounting Standard 1- Disclosure of Accounting Policies, the change in depreciation method results in a change in the accounting estimate of a firm but it does not imply that the company has changed its accounting policy.
The company, when changing its depreciation method, needs to disclose the same in the footnotes of an accounting statement. In addition to this, the justification and financial effects of the particular change is also to be fully disclosed by the company.
Reporting a Change in the Depreciation Method
In case a firm is considering changing the method used to depreciate the assets of the entity, the same can be done and for change in the accounting method is required to be disclosed with a justification for its action and also provide the documents supporting its reason for the change.
If the decision is positive then the company is required to post a footnote in the annual report declaring the change in the method of depreciation and the reason for the same.
Example for explaining the Change in the Depreciation Method
The following mentioned example will clarify the doubts related to how to change the depreciation method.
Consider a company buying an asset worth Rs. 1,00,000 have an expected useful life for four years. It was after two years that the company decided to change the method of depreciation from the straight-line method to the written down value method at the rate of 10%.
The depreciation for the third and fourth year is to be calculated.
Solution:
Step 1: Evaluate the carrying amount at the date when the depreciation method is changed.
The method of depreciation is changed after two years so first, the asset is to be depreciated for two years using a straight-line method.
1,00,000 / 4 = 25,000 per year
For two years the value will be = 25,000 x 2 = 50,000
Therefore, the asset’s carrying amount at the end of two years was 50,000 (1,00,000 – 50,000)
Step 2: Now this step, the assets are to be depreciated using the changed depreciation method (written down value method) from the date of the change.
The asset’s carrying amount at the date of change was = 50,000
New depreciation method = Written down value method @ 10%
Depreciation for the third year = 50,000 x 0.10 = 5,000
Depreciation for the fourth year = 45,000 x 0.10 = 4,500
Conclusion
Depreciation methods are tools that companies and businesses use to account for our personal and business costs. They include inventory, machinery, physical facilities, and of course, money. If there is a change in the consumption pattern of the economic benefits, then the firm might have to change its depreciation methods so that accurate accounting estimates can be evaluated.
