Question

1. what are the factors used in determining depreciation? Which is preferred for tax purposes? Why? Can prior years be revised? Why or why not? Could a company’s books be prepared under one method and tax another? Why is there focus on depreciation?

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Answer 1

Depreciation - Depreciation is the gradual reduction in the value of the asset. The value diminishes due to constant usage and obsolescence. Depreciation is provided only for fixed assets, such as plant, machinery, equipment, building and furniture. Depreciation is never provided on assets that are current in nature. Current assets include cash, stock in hand and receivables. There are several factors that help in determining the annual depreciation of the asset.

1. Cost of the Asset- The costs incurred to purchase the asset play a very important role in determining the depreciation value. The cost of the asset is the amount paid to acquire it plus the costs of installing it minus the discounts received by the seller. If the company incurred high costs to purchase it, it is very unlikely to replace the asset very soon.

2. Estimated Useful Life- The estimated useful life also has a bearing on the determination of depreciation. If the asset is likely to be useful for many years to come, it is going to be depreciated each year annually at a lower rate than if its lifespan were estimated to be very low. The estimated useful life is computed after analyzing the productive capabilities of previously used, similar types of asset.

Depreciation offers businesses a way to recover the cost of an eligible asset by writing off the expense over the course of the useful life of the asset. The most commonly used method for calculating depreciation under generally accepted accounting principles, or GAAP, is the straight line method. This method is the simplest to calculate, results in fewer errors, stays the most consistent and transitions well from company-prepared statements to tax returns.

Depreciation using the straight line method reflects the consumption of the asset over time and is calculated by subtracting the salvage value from the purchase price of the asset, and then dividing that amount by the projected useful life of the asset. For instance, say a catering company purchases a delivery van for $35,000. The expected salvage value is $10,000 and the company expects to use the van for five years. By using the formula for the straight line method, the annual depreciation is calculated as (35,000 - 10,000) / 5 = 5,000. The van depreciates at a rate of $5,000 per year for the next five years.

Useful life of asset: The period for which asset is expected to stay operational may change.

Factors that may invoke revision of useful life of asset-

• Change in use and application of asset e.g. working for longer hours, used by untrained workers.
• New information obtained that is different from previous estimates and expectations
• Damage resulting in shorter useful life

All businesses that are required to file a tax return must maintain records. But the records they keep for tax purposes may be different than the records they need for business purposes.

If a company is required to or chooses to comply with Generally Accepted Accounting Practices (GAAP), they will typically follow an accrual-basis method for reporting revenue. Their tax records, on the other hand, must comply with the Internal Revenue Code, which recognizes Cash, Accrual or a Hybrid Accounting Method as valid methods of reporting. If the company is not using the same accounting method for both sets of books, the income that gets reported on their financial statement may not match the income they report on their tax return.

The difference between Book Income (Loss) and the Tax Income (Loss) is reported on the tax return for larger entities that meet certain revenue and asset requirements.

Depreciation is provided for the assets with a view to achieve the following results:

1. To Ascertain the True Working Result:

Asset is an important tool in earning revenues. Huge amounts are spent for acquisition of assets which are worn out in the process of earning income. Thus, the assets get depreciated in their value, over a period of time due to many reasons explained above.

When the value of assets decreases, this loss must be brought into account; otherwise a true working result cannot be known. Depreciation is an operating expense of a physical asset, the same should be considered in arriving the true profit earned during each year.

The basic need of depreciation is to ascertain the true income. If depreciation is ignored, the loss that is occurring in respect of fixed assets will be ignored. So, depreciation should be debited to Profit and Loss Account before profit is ascertained.

2. To Ascertain True Value of Asset:

The function of the Balance Sheet is to show the true and correct view of the state of affairs of a business. If no depreciation is charged and when assets are shown at the original cost year after year, Balance Sheet will not disclose the correct state of affairs of a business.

3. To Retain Funds for Replacement:

Assets used in the business need replacement after the expiry of their service. It is always not possible to determine the useful life of assets. But, in certain cases, machine often becomes, obsolete long before it wears out because of rapid changes in tastes and technology. It is a permanent loss in value of the asset. When an asset is continuously used, a time will come when the asset is to be given up and hence its replacement is essential.

4. To Reduce Tax Liability:

Depreciation is a tax deductible expense. As such, it is permitted by the prevailing taxation laws to be deducted from profit. Consequently, the owner of a business may avail himself of this benefit by charging depreciation to his profit and reducing his tax liability.

5. To Present True Position:

Financial position can be studied from the Balance Sheet and for the preparation of the Balance Sheet fixed assets are required to be shown at their true value. If assets are shown in the Balance Sheet without any charge made for their use, (that is, depreciation) then their value must have been over­stated in the Balance Sheet and will not reflect the true financial position of the business.

Therefore, for the purpose of reflecting true financial position, it is necessary that depreciation must be deducted from the asset and then at such reduced value may be shown in the Balance Sheet.