The Importance of a Depreciation Policy in Indian Accounting Practices

Depreciation is the most vital component in accounting, which allocates the cost of fixed tangible assets over their useful lives. The companies operating in India should work out a clear-cut policy on depreciation with a view to fairly presenting the financial statements. Specifically, we expect this policy to consider the depreciation method, the useful lives of assets, and residual values. Understanding how changes in the accounting policy related to depreciation are maintained and disclosed in the financial statements is part of maintaining transparency and regulatory compliance. 

Methods of Depreciation

There are various methods to calculate depreciation, each affecting financial statements differently. In India, the two most commonly used methods are the Straight-Line Method (SLM) and the Written Down Value (WDV) method. 

• Straight-Line Method (SLM)
  This method charges the cost value of an asset over the useful life of that asset uniformly. For example, if a business acquires machinery costing ₹ 10,00,000 with a useful life of 10 years and a scrap value of ₹ 1,00,000, then the depreciation charges each year will be of ₹ 90,000. The process is to subtract the residual value from the cost of acquisition and divide by the useful life of the asset (₹ 10,00,000 – ₹ 1,00,000 ÷ 10). 
• Written Down Value Method (WDV)
  The calculations for WDV are done by applying a constant percentage to the book value of the asset every year, so the depreciation will be higher in the initial years. For example, if the similar machinery was to be depreciated @ 20% p.a., then in the first year, the depreciation would be ₹2,00,000 (20% of ₹10,00,000), and for the second year, it would be ₹1,60,000 (20% of ₹8,00,000). 

Defining Useful Lives of Assets

The useful life of an asset is the life for which an asset is counted to be employed by a business. If useful life is estimated correctly, this would eventually assist in measuring the annual depreciation. For instance: 

• Buildings: Normally with an economic life of 30 years. 
• Computers and Electronics: Generally, has a shorter useful life, varying from 3 to 5 years. 
• Machinery: Equipment can be in working condition for a period of 10 to 15 years, depending on the industry. 

Establishing Residual Values

A residual value of an asset refers to that amount an entity estimates to realize at the end of the useful life after deducting the estimated costly disposal. For instance, if a company expects to sell machinery that cost Rs.1,000,000 for Rs.100,000 at the end of its 10-year useful life, the residual value of such machinery is Rs.100,000. 

Importance of a Comprehensive Depreciation Policy

A well-defined depreciation policy is crucial for plenty of reasons: 

• Consistency in Financial Reporting
  It ensures consistency in the computation and accounting for the depreciation of assets during financial periods; therefore, it is then easy to compare financial performance across financial periods over several years. 
• Adherence to Regulation
  Formulating a precise and clear policy implies that the company is compliant in the eyes of the law and various regulatory legislation, as the ICAI and the Companies Act, 2013 also lay down the accounting standards. 
• Preparation of Accurate Financial Statements
  A clear definition of useful life and residual value implies that the financial statements will accurately portray the true and fair value of the company’s assets, which is essential for investors, creditors, and regulatory bodies. 
• Tax Planning
  A clear and precise policy is crucial, as it enables the company to plan and manage taxes more effectively. Depreciation is an income tax deduction that directly relates to a taxpayer’s taxable income. 

Handling and Disclosing Changes in Depreciation Policy

The reasons for the changes in the policy of depreciation could be due to any changes in the accounting standards, changes in the management’s perspective, or a changed pattern of usage of the assets. Therefore, it is crucial to meticulously account for and disclose any changes in the depreciation accounting policy in India. 

• Impact on Financial Statements
  Such changes can have significant impacts on the financial statements. For instance, switching from SLM to WDV may result in a higher depreciation expense in the initial years, leading to a lower net profit.
• Disclosure Requirements
  Indian Accounting Standard (Ind AS) 8 mandates the disclosure of changes in accounting policies, including depreciation, in the financial statements. There shall be a description of the nature of the change, the reasons for the change, and the financial effect of the change. 
• Application Methods
  Both prospective and retroactive applications of the modifications are possible. Prospective application means implementing the new policy from the current period forward, without making any adjustments to previous periods. The retrospective application implies restating the changes in the prior-period financial statements as if the new policy had always been in place. 

Questions to test Understanding

Qus: 1:What is the primary purpose of accounting depreciation? 

1. a) To enhance the value of an asset over time
2. b) To allocate the cost of fixed tangible assets over their useful lives
3. c) To decrease tax liabilities
4. d) To artificially improve financial statements.

Qus 2: Which two depreciation methods are most popular in India? 

1. Accelerated and Decelerated Depreciation
2. Straight-Line Method (SLM) and Written Down Value (WDV) Method
3. Units of Production and Sum-of-the-Years-Digits
4. Component Depreciation and Group Depreciation

Qus 3: How does the Straight-Line Method (SLM) calculate depreciation? 

1. a) Apply a constant percentage to the book value each year.
2. b) by uniformly allocating the cost value over the asset’s useful life.
3. c) Considering the asset’s usage pattern
4. d) By estimating future cash flows

Qus 4: Why is it essential for companies in India to have a well-defined depreciation policy? 

1. a) To enhance the physical condition of assets
2. b) To ensure consistency in financial reporting, compliance with regulations, and accurate financial statements.
3. c) To reduce the lifespan of their assets
4. d) To avoid recording depreciation in financial statements.

Qus 5: According to Indian Accounting Standard (Ind AS) 8, what must be disclosed when there is a change in depreciation policy? 

1. a) Only the financial effect of the change
2. b) The nature of the change, reasons for the change, and the financial effect of the change
3. c) The names of the individuals approving the change
4. d) The cost of new assets purchased

Conclusion 

Therefore, Indian businesses require a robust depreciation policy to prevent inconsistencies, lack of clarity in presentation, omissions and errors, as well as unreliability and lack of comparability in financial reporting. It facilitates regulatory compliance, proper and fair financial presentation, and effective tax planning. Correct handling and clear disclosure of changes in the depreciation policy improve financial statements’ credibility and instill trust in stakeholders. Therefore, the existence of a set and clear policy on depreciation allows companies to manage and plan strategically.