The Hindu Business Line : Take note of ‘depreciation’

It is common knowledge that depreciation is a measure of accounting for the wear and tear of an asset arising from use, obsolescence or passage of time. It is important to keep track of the depreciation figures reported by a company as a steep rise in depreciation could unexpectedly suppress earnings, however profitable a company’s operations may be.

For example, the calculation of additional depreciation on expanded capacities may cause a surge in depreciation figures. Until this newly created facility is able to generate substantial revenues, the burden of higher depreciation could dent existing profits.

Change in measurement, policy

Take a look at Maruti Suzuki’s results for the first quarter of 2009. A 20 per cent growth in net sales in the first quarter has led to a disappointing 7 per cent fall in profits. While we can promptly point fingers at increased input costs, a closer look at the numbers reveals that depreciation too is partly to be blamed. After all, it has doubled from Rs 82 crore in June 07 quarter to Rs 166 crore now. Similarly, in the fourth quarter of 2007-08 too, profits fell by a whopping 34 per cent year on year, courtesy, depreciation, which rose from Rs 71 crore in the same period last year to Rs 311 crore in January-March 2008.

Why did this happen ? Because the company effected a change in the way it measures depreciation. Let’s break it down a bit.

The discerning amongst you would know that 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.

In Maruti’s case, the company made a change in the ‘useful life’ of certain assets with effect from April 1, 2007, bringing down the lifecycle of its tools and equipment to eight years instead of thirteen and for dies, four years instead of five.

While the above is an example of a change in measurement, depreciation figures 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.

Accounting for the change

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 is put to use; any deficiency or surplus arising from this recomputation will be adjusted in the year in which the method is changed.

Where to look

The best place to find information on all this is the schedules to the balance sheet and notes to accounts in the company’s annual report or quarterly results. 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 explains the accounting treatment to give us an idea of how the depreciation of that particular year has been arrived at.

So, the next time you find a fall in a company’s profits compared to the previous period, look again! 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.

While so far, we have discussed a possibility of higher depreciation suppressing profits, there may also be situations where profits receive a leg-up because of lower depreciation. For instance, TCS, in the first quarter increased the useful life of computers from two to four years. This boosted profits by an estimated Rs 50 crore. In such a situation, beware! The company’s profits from operations is actually lower.

Under both these circumstances, you can alternatively compare the operating profits (earnings before interest, depreciation and taxes) to see how well the company has performed.

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