Deciphering depreciation

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.

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