Deciphering depreciation
BL RESEARCH BUREAU
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Depreciation is a measure of accounting for the wear and tear of an
asset arising from use, obsolescence or passage of time. But did you
know that it is as important to keep track of depreciation figures
reported by a company as any other cost?
A steep rise in depreciation could unexpectedly suppress earnings,
however profitable a company's operations may be.
For example, the calculation of depreciation on expanded capacities
may cause a surge in depreciation figures. Until this newly created
facility is able to generate substantial revenues, higher depreciation
could dent existing profits. Consider Adani Power. Total depreciation
almost quadrupled in the June 2011quarter over the year-ago period.
Net profits grew a tamer 55 per cent against the 131 per cent growth
in revenues. In some cases, however, depreciation is affected by
factors other than capacity or asset additions.
Change in measurement, policy
Depreciation is calculated as Cost – Estimated residual value/Life of
the asset. A change in any one of these measures — cost, residual
value or life — will result in a change in the amount charged as
depreciation.
Depreciation may also be affected by a change in method/accounting
policy. For example, a company has so far calculated depreciation
under the ‘straight line' method and now decides it will be under the
‘ written down value' method. Shoppers' Stop, for instance, modified
depreciation policies twice in the past four years, resulting in
fluctuating depreciation outgo.
Any change in depreciation caused by an alteration in the cost of the
asset, the residual value or the life will have a prospective effect
in the books of accounts. This means that if in the fifth year, the
life is reduced from ten years to eight, the unamortised amount will
be charged to revenue over the remaining life of three years (eight
minus five). For a change in policy, the amount will be recomputed on
a retrospective basis from the date in which the asset was put to use;
any deficiency or surplus arising from this re-computation will be
adjusted in the year in which the method was changed.
Where to look
The best place to find this information is the schedules to the
balance sheet and notes to accounts. The schedule on ‘ Significant
Accounting Policies' will give the method and rates of depreciation,
along with other accounting treatment specifically followed by the
company. The ‘notes to accounts' section explains the accounting
treatment to understand how the depreciation of that particular year
has been arrived at.
Depreciation, although treated as an expense, is an item that does not
involve cash outflow. And in years of abnormally high depreciation due
to factors discussed above, the company's profitability may not be bad
as it seems. There may also be situations where profits receive a
leg-up because of lower depreciation. In such a situation, beware! The
company's profits from operations are actually lower. Under both
circumstances, you can alternatively compare the operating profits
(earnings before interest, depreciation and taxes) to see how well
your company has performed.
BL RESEARCH BUREAU
(This article was published in the Business Line print edition dated
September 11, 2011)
BL RESEARCH BUREAU
Share · print · T+
Depreciation is a measure of accounting for the wear and tear of an
asset arising from use, obsolescence or passage of time. But did you
know that it is as important to keep track of depreciation figures
reported by a company as any other cost?
A steep rise in depreciation could unexpectedly suppress earnings,
however profitable a company's operations may be.
For example, the calculation of depreciation on expanded capacities
may cause a surge in depreciation figures. Until this newly created
facility is able to generate substantial revenues, higher depreciation
could dent existing profits. Consider Adani Power. Total depreciation
almost quadrupled in the June 2011quarter over the year-ago period.
Net profits grew a tamer 55 per cent against the 131 per cent growth
in revenues. In some cases, however, depreciation is affected by
factors other than capacity or asset additions.
Change in measurement, policy
Depreciation is calculated as Cost – Estimated residual value/Life of
the asset. A change in any one of these measures — cost, residual
value or life — will result in a change in the amount charged as
depreciation.
Depreciation may also be affected by a change in method/accounting
policy. For example, a company has so far calculated depreciation
under the ‘straight line' method and now decides it will be under the
‘ written down value' method. Shoppers' Stop, for instance, modified
depreciation policies twice in the past four years, resulting in
fluctuating depreciation outgo.
Any change in depreciation caused by an alteration in the cost of the
asset, the residual value or the life will have a prospective effect
in the books of accounts. This means that if in the fifth year, the
life is reduced from ten years to eight, the unamortised amount will
be charged to revenue over the remaining life of three years (eight
minus five). For a change in policy, the amount will be recomputed on
a retrospective basis from the date in which the asset was put to use;
any deficiency or surplus arising from this re-computation will be
adjusted in the year in which the method was changed.
Where to look
The best place to find this information is the schedules to the
balance sheet and notes to accounts. The schedule on ‘ Significant
Accounting Policies' will give the method and rates of depreciation,
along with other accounting treatment specifically followed by the
company. The ‘notes to accounts' section explains the accounting
treatment to understand how the depreciation of that particular year
has been arrived at.
Depreciation, although treated as an expense, is an item that does not
involve cash outflow. And in years of abnormally high depreciation due
to factors discussed above, the company's profitability may not be bad
as it seems. There may also be situations where profits receive a
leg-up because of lower depreciation. In such a situation, beware! The
company's profits from operations are actually lower. Under both
circumstances, you can alternatively compare the operating profits
(earnings before interest, depreciation and taxes) to see how well
your company has performed.
BL RESEARCH BUREAU
(This article was published in the Business Line print edition dated
September 11, 2011)
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