Reducing Balance Method, A Confusion

[Checkmated]

According to IAS 16 Depreciation is the allocation of depreciable amount,and depreciable amount is Cost less Residual value.

In straight line method we depreciate the depreciable amount (cost less residual value) i.e if cost is 4000 and residual value is 2000 and depreciation rate is 10 % , we calculate depreciation as
(4000-2000)x 10%

So what we will do in Reducing balance method, in the books the residual value has not be deducted while calculating depreciation through reducing balance method and instead of depreciable amount, depreciation is taken on cost.
Our teacher who is a Chartered Accountant has said that in reducing balance method too, we will not take depreciation on cost and we will calculate depriciation on cost less residual value i.e on depreciable amount and in that way we will comply with the IAS 16 definition of depreciation. We showed him books but he said show me any line of any IAS that says "Depreciation should not be taken on depreciable amount but it can taken on cost".

Now tell me how will be depreciation charged according to IAS under reducing balance method, on depreciable amount or on cost, if on cost then why?

[Checkmated]

26 views but no replies !!! KamranACA or someone else please comment.

[kamranACA]

Dear,

I dont wish to feel suspecious about the non-updated books used by the students. However, teachers should suggest good latest books to students and if no such book is available, students should be guided to use orginal IFRSs, Laws etc to get hold of the correct knowledge.

Previous to latest changes in IASs (applicable from 2005), residual value concept was present in IAS 16 and it was required to be determined and deducted from the cost to calculate the depreciable value.

I, before going to further discussion on residual values, want to make it very very very much clear that residual values have to be determined and deducted from the costs to arrive at the depreciable amount/value either the entity is using Straight-line method or Diminishing balance method. This has to be done in similar way irrespective of whatever depreciation method is to be used. The selection of one of above depreciation methods is to reflect the pattern in which the asset's future economic benefits are expected to be consumed by the entity. (Paragraph 60 of IAS 16). It has nothing to do with determination of depreciable amount.

Now coming back to residual values, it must be noted that since the recent change in IAS 16, entities are now required to assess the residual values constantly (at least on each financial year-end)for any change in their estimate and adjustments should be made in depreciable amount, if the subsequent estimate of residual values would be different from the previous residual value estimate. (Paragraph 51 of IAS 16). Such change in estimate will be accounted for as suggested by IAS 8.

However, I also want to place on record that residual values in practical terms might be very much insignificant and need not to be deducted from cost to determine depreciable amount. IASs are not intended to be applied on immaterial issues. I refer paragraph 53 of IAS 16 which states that

"the depreciable amount of an asset is determined after deducting its residual value. In practice, the residual value of an asset is often insignificant and therefore immaterial in the calculation of the depreciable amount."

This paragraph no where exempted any particular depreciation method from the residual value provisions. However, it also provided for the immateriality of residual values which are insiginificant and may not be given any effect while calculating depreciable amount.

It is very much crucial to understand that why residual values have to be determined so fairly/accurately and why these have to be deducted from cost for calculation of depreciation.

What I understand is, IAS 1 has also recently required that PROFIT FROM OPERATING ACTIVITIES/OPERATIONS has not to be disclosed seprately from other activities. (paragraph IN 13 of Introduction section of IAS 1). [We do this becoz Fourth Scedule of Companies ordinance 1984 requires it and CO84 overrides IFRSs]. Further, profit from ordinary activities has not to be disclosed seprately from profit from extra ordinary activities/items. (IAS 1, paragraph 85).

It appears that everything has to be taken to and depicted by operations and there has been eliminated the concept of non-operating income/revenue. If residual values of fixed assets would be accurately determined and adjusted for charging depreciation, the carrying values of such assets would almost almost depict their fair value as at least the residual values have been assessed on fair value basis approximately. (this is just my estimation and apprehension).

This way the Other Income portion of a profit and loss account will considerably be reduced on account of sale of such fixed assets, if any, thus keeping the operational profit as a meterail figure.

This also correlates to the endeavor made by stipulating the determination of residual values in order to keep the depreciation charge a correct figure that should either not be overstated or understated. If depreciation charge would be accurate, any gain/loss on disposal of any item of fixed asset would not enormous, unless in some extra ordinary circustances.

At the end, replying to ur query once again, yes, residual values have to be dedcuted even if entity is using diminishing balance method. Your teacher is correct and book may be wrong. However, the book might have ignored residual values on account of immateriality. You have to look at the figures of residual values to assess.

Best regards,

Kamran.

[Checkmated]

Thanx for the detailed reply,

As u have said "yes, residual values have to be dedcuted even if entity is using diminishing balance method."

But the problem is that i have not come across any book or any article even on the internet where, in the diminishing balance method , residual value is deducted from cost and then depreciation is taken on that even if the residual value is MATERIAL. Wiley series book of Abbas Ali Mirza has also said that in diminishing balance method depreciation is taken on cost and at the end of the useful life residual value will be left. the example given by Wiley Series is that,

Example
Double-declining balance depreciation (if salvage value is to be recognized, stop when book value = estimated salvage value)
Depreciation = 2 x Straight-line rate x Book value at beginning of year
Another method to accomplish a diminishing charge for depreciation is the sum-of-the-years' digits method, that is commonly employed in the USA.



Assume the following
Taj Mahal Milling Co., a calendar-year entity, acquired a machine on June 1, 2002, that cost $40,000 with an estimated useful life of four years and a $2,500 salvage value. The depreciation expense for each full year of the asset's life is calculated as follows

Straight-line
Year 1 37,500 [a] ÷4 = 9,375

Year 2 9,375
Year 3 9,375
Year 4 9,375
[a]$40,000 - $2,500.



Double-declining balance
50%x40,000 =20,000
50%x20,000 =10,000
50%x10,000 =5,000
50%x5,000 =2,500

You can see in the example , in straight line method depreciation is taken on cost less residual while in diminishing balance method, depreciation is taken on cost.


Also what we read in Module C are updated books, version 2007. We read TRM by PBP written by Maqbool Sahib FCA. Even i have searched on internet and have not come across any example where in both straight line and diminishing balance method depreciation is taken on cost less residual value. In every book and every website i have come across that in straight line method take depreciation on cost less residual but in diminishing method take depreciation on cost. Now it is very difficult for me to absorb that everyone is wrong here, and certainly in the papers if the question comes which way we have to adopt while taking depreciation.

[kamranACA]

Dear,

Accounting has to be done under some identifiable accounting framework. The books written by various international writers could portray varying methodologies that might be attributed due to different applicable frameowrks.

In Pakistan the applicable accounting framework is Companies Ordinance, IFRSs and any other law relevant to preparation of accounts of some entity.

UK or USA have varying frameworks due to local laws, local standards and other pronouncements.

However, as a student of accountancy in Pakistan, you have to follows applicable IFRSs and local laws where they override the IFRSs.

IAS-16 (being an IFRS) no where allows for or provides for ignoring residual value in the determination of depreciable amount where diminishing balance method is being used. For this purpose, I advise you not to follow merely the books which do not conform to IFRSs. You must have to study IAS-16 in original with all of its BASIS OF ACCOUNTING. Then you would be appreciated to discuss with me the issue of residual value.

Infact, people get disturbed form this concept becoz depreciation charge in straightline method is very much accelerated as compared to diminishing balance method on similar depreciation rate. An entity should determine the useful lives of fixed assets accurately and use the depreciation rates accordingly. The depreciation rates on straightline method, in my view, should not be equal to depreciation rates on deminishing value method, if useful is same.

However, determination of useful life/depreciation rate and determination of residual value are two different issues.

My opinion on your above question is still un-altered. A number of companies using diminishing balance method have re-assessed residual values and made required adjustments in the accounts last year, being the first year after change in IAS-16 regarding re-assessment of residual value at least at each financial year-end.

You please visit the stock exchange's library and study the annual reports/accounts of at least ten manufacturing companies and you will find such adjustments and disclosures of change in accounting estimates under IAS 8 in this regard.

Some companies might have not done this due to immateriality but their accounting policy on Property, Plant and Equipment will depict that such a re-assessment has been made every year.

However, re-assessment does not necessarily result in adjustment for change in accounting estimate due to materiality reasons.

You are once again advised to study IAS-16. (Revised).

Best regards,

Kamran.

[IsfandyarACCA]

to find out the rate of depreciation in reducing balance method is r=1-n underroot s/c cant write the proper formula you can see it yourself somewhere , r= rate 1 constant of formula, n=years, s = residual value and c=cost. means if you find out the rate via formula which derived purely from mathematics as it is mentioned in text book F3. you put the residual value in formula this means there is no need to deduct it from the cost again as the formula has already adjusted the figures. and reread the example and se the net book value at end, it should be equal to the residual value, this means formula works perfectly.