The Hindu Business Line : Depreciation volatility under IFRS

Depreciation under the IFRS would add huge volatility in numbers and also make forecasting much more difficult, not to mention the administrative effort of compliance.

Under the IFRS, there is no concept of minimum rate of depreciation.

Paul Alvares

Depreciation is one of the most significant items on a company’s balance-sheet, be it a manufacturing or a service company. Under the Indian Generally Accepted Accounting Principles (GAAP), depreciation as a cost is relatively stable and also predictable due to its stable nature. This makes forecasting and budgeting under Indian GAAP simpler.

However, under the proposed International Financial Reporting Standards (IFRS), depreciation will be more volatile and relatively less accurately predictable. There are certain provisions in the IFRS which will have a significant impact on depreciation.

Estimated useful life

Under the Indian GAAP, depreciation is provided at the higher of the rates based on Estimated Useful Life (EUL) or Schedule XIV. Most companies in India typically assume Schedule XIV as the EUL and may have rarely done any separate evaluation of EUL. Under the IFRS, the concept of useful life is based on the number of years that the entity expects to use the asset, which may be significantly shorter than the economic life of the asset.

Economic life

A company engaged in the business of car rentals or truck hire may be depreciating its vehicles over six years based on Schedule XIV, whereas under the IFRS, it may require to depreciate it based on its economic life, which will not be more than three years. Hence, in such cases, the depreciation charge under the IFRS would be much higher.

Most companies tend to discard critical assets much earlier than their economic life and hence may run a risk of higher depreciation under the IFRS due to lives being shorter than economic lives.

Again, a company engaged in transporting oxygen through cylinders may use the cylinder for, say, 2-3 years compared to the useful life as per Schedule XIV which is 6-7 years and this is generally done because of the reputation risk involved. In such cases the depreciation would be higher.

Minimum depreciation rate

Further, under the Indian GAAP, there is a minimum depreciation rate, which is mandatory for companies to provide, even though the actual usage could be over a much higher useful life. Under the IFRS, there is no concept of minimum rate of depreciation. Due to this, the charge under the IFRS could be much lesser than that under Indian GAAP for such assets.

Let’s say an automobile company has a mould/pattern that is used in the production of a particular part and the company provides depreciation based on unitary method (that is, number of units produced).

Under the Indian GAAP, even if there is no production of the part during a particular period, the minimum Schedule XIV rate of depreciation needs to be provided, whereas, the same may not be the case under the IFRS.

residual values

Under the Indian GAAP, residual values are fixed at the inception and do not change generally over the life of the asset.

Also, most companies estimate residual values to be nil. In the case of IFRS, residual values are required to be re-evaluated at each financial year-end. In certain industries where assets such as ships and aircraft are used or industries where there are significant real estate like buildings, the residual values could change significantly over periods.

This may bring about significant volatility in the depreciation charge each year.

Under the Indian GAAP, many companies in practice determine useful lives at the time of the acquisition of the asset and they generally don’t change over the life of the asset. The IFRS requires useful lives to be re-estimated at least every year. This not only adds significant amount of administrative effort but may also result in volatility of numbers every year.

One blessing in disguise under the IFRS is that the change in depreciation method is treated as a change in estimate unlike in the Indian GAAP, where it is treated as change in accounting policy.

The implication of this being that under the Indian GAAP, one has to do a retrospective recalculation of depreciation from the date of past purchase, which can be a painful task compared with the IFRS, where it has to be done prospectively from the date of change.

Hence, as can be seen, depreciation under the IFRS would add huge volatility in numbers and also make forecasting much more difficult, not to mention the administrative effort of compliance with the IFRS. Although the changes and its extent would vary from company to company, an important matter to note is that the area of fixed assets accounting will need a huge amount of effort.

Most companies in India, especially core manufacturing companies, have huge asset bases and getting down to the nitty-gritty of the IFRS and concluding on them would involve a significant amount of time. This time would include not only accounting effort like identifying components, fair valuation, to name a few , but will also comprise effort relating to changes in IT systems, assessing ability of IT systems to handle complexities of dual accounting, etc.

Companies that have set on the IFRS path have realised the benefits of having undertaken this exercise much earlier. Many large companies in India have already embarked on the IFRS and for the ones that have not, it may be time to make a beginning.

(The author is a senior professional in a member firm of Ernst & Young Global.)

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