Preferred method for depreciation.

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Preferred method for depreciation. - Schuaeb - 01-25-2011

Dear all,

What in your opinion should be the preferable method for calculation of depreciation allowance, reducing balance method or straight line method? And what can be the reason for such preference?

Regards
Shoaib

- kamranACA - 01-25-2011

In my view straightline method is more logical since using such method demonstrates to the users of accounts that in how much definitive time the value of asset will be consumed in operations. This may provide an impetus for resreving funds in order to finance the due replacements and BMR etc with a better vision. However, this opinion can look childish and theoratical for many reasons in the detail of which I would not go.

Despite my above views, I always advise people to follow reducing balance method. This is because people at large don't have good computerized systems which can ensure that depreciation is not charged on fully depreciated assets; which is always a threat in case of straightline method. If such record is maintained manually, it is always subject to erros and a lot of cumbersome exercise.

So to avoid it, reducing balance method may be called preferable. Specially for those who don't have sophisticated systems and resources.

Regards,

- Schuaeb - 01-29-2011

Thanks Kamran sb for the reply.

Now what if it is claimed that reducing balance method is closer to the reality especially for such assets that are not designed to produce a fixed number of units evenly over a fixed period of time. For assets that are more productive in the initial year (generally it is the case) reducing balance method better matches the depreciation expense with the revenue. IAS 16 does not specify any of the methods as benchmark however the best possible estimate it requires.

In my view reducing balance method is more in practice. I never thought of the reasons until I was asked the same. May be it's due to in addition to the reason provided by you, to avoid deferred tax implications (if tax rates used, however, it's not often the case)

Kindly elaborate the following lines also.

<blockquote id="quote">quote<hr height="1" noshade id="quote">Originally posted by kamranACA
 This may provide an impetus for resreving funds in order to finance the due replacements and BMR etc with a better vision. <hr height="1" noshade id="quote"></blockquote id="quote">

Thanks

- kamranACA - 01-31-2011

The presumption that assets bring more revenues in initial years and it keeps on reducing with the passage of time, is bit logical but is rebuttable as well.

We see that when new plants/industries are established, these have lesser market share, lesser revenues, more advert costs, more financing costs etc; so in such cases larger amount of depreciation would not bring good picture of the affairs.

Further, using either straight line or reducing balance has nothing to do with any exemption from deferred taxation calculations. Two basis can alter the figures to be arrived at; but none of them outways the requirements to provide for deferred taxation. Whatever method you use, the taxable differences would always arise due to accelerated allowances given by tax laws against the accounting rates.

Reducing balance method is simple for record keeping of the individual assets while straight line is bit tougher and requires lot of discpline. In straight line method, if you don't have sophisticated systems (specially in larger business entities), or you don't entail huge cumbersome calculations/record keeping for individual assets, there would always be a threat of charging depreciation on the fully depreciated assets.

What I said about replacements or BMR has in fact nothing to do DIRECTLY with any depreciation method, yet when the entraprenure knows that the asset would be charged off fully in say 10 or 15 years (it may in fact not be ceasing after such time practically); they tend to have better planning for its replacements/BMRs and put more appropriate capex estimates in their business plans and financial models. In some cases, this proves to be a psychological impact only.

Practically speaking, reducing balance method is easier and results in lesser mistakes over the longer run, specially in large entities.

Regards,

- Schuaeb - 01-31-2011

Dear Kamran

<blockquote id="quote">quote<hr height="1" noshade id="quote">Originally posted by kamranACA
 The presumption that assets bring more revenues in initial years and it keeps on reducing with the passage of time, is bit logical but is rebuttable as well.

We see that when new plants/industries are established, these have lesser market share, lesser revenues, more advert costs, more financing costs etc; so in such cases larger amount of depreciation would not bring good picture of the affairs.
<hr height="1" noshade id="quote"></blockquote id="quote">

This may only be true for an entity undertaking a new business. For new plants installed by existing industries normally their performance deteriorates over time hence reducing balance method may be more realistic estimate.

<blockquote id="quote">quote<hr height="1" noshade id="quote">Originally posted by kamranACA
 
Further, using either straight line or reducing balance has nothing to do with any exemption from deferred taxation calculations. Two basis can alter the figures to be arrived at; but none of them outways the requirements to provide for deferred taxation. Whatever method you use, the taxable differences would always arise due to accelerated allowances given by tax laws against the accounting rates.
<hr height="1" noshade id="quote"></blockquote id="quote">
Not taking into account initial depreciation allowance if any and using depreciation rates as provided by tax laws as accounting rates for depreciating assets can there be a deferred tax liability?

Through this discussion I wanted to know the factors to be considered while adopting method for depreciating assets. And your points have been useful.

Regards

- kamranACA - 01-31-2011

Of course the performance of an asset reduces over the time, provided the BMR activity is not undertaken. Due to this, reducing balance method may be a better measure.

However, this is not a hard and fast rule; even in the established industries, when you introduce new product lines or enhance the capacity of existing plants, there is always a threat of getting the upfront market share (in both cases). We have seen a lot of such examples in various industries specially the consumer products and food industries. Inspired of the market situation, people jump into capacity enhancements and new products and then they have to wait for longer tenures to get the product memorized by end-consumers. Just look at new juices, edible oils, shampoos, detergents and other such products.

However, this has been untrue in case of some other industries like cement; where people enhanced capacities unbelievably and still kept on absorbing their produce in the market with no hassle.

So, this is subjective and can be witnessed both ways.

Practically, there are always differences between tax base and accounting base of PPE assets due to accelerated allowances given by tax laws; one example you quoted is initial allowance. In other countries you may be seeing extra shift allowances as well as investment allowances with respect to BMRs etc. This was also practiced in Pakistan in earlier years. People also have different recognition/capitalization criteria against the tax laws. Even if you have same depreciation rates and you have no initial allowance for, say last two years, the temporary differences would arise on account of such allowances enjoyed in previous years. Why? Because due to earlier yearsâ acceleration of depreciation under tax laws, your WDVs (accounting and tax bases) would differ and keep on differing forever.

However, if you get a unique case where depreciation rates are same, tax and accounting bases are same, historically no acceleration has ever been allowed; then you are right, there would arise no temporary difference.

Regards,

- bilalfca - 02-14-2011

salam.
well, i think & as prescribed in IAS-16, that method of depr. should be used that truly reflects the expected consumption of any particular asset keeping in view the other factors like obsolescence etc in mind.
Thanks.