Tuesday, December 23, 2014

Wrong application of Depreciation Policy in Nepal

What is Depreciation?
Depreciation is the systematic allocation of the depreciable amount of an assets over its useful life. The depreciable amount is determined after deducting its residual value. The following four factors are considered in determining the useful life of an assets:
  • Expected use of assets.
  • Expected physical wear and tear.
  • Technical or commercial obsolescence arising from changes or improvements in production or from a change in the market demand for the product or service output of the assets.
  • Legal or similar limit on the use of assets, such as the expiry dates of related leases.
To calculate the depreciation amount, we shall select correct depreciation method based on the nature of an organization. Expected future economic benefit of the assets used by entity should be reflected by the depreciation method used by the entity. Different depreciation methods can be used to allocate the depreciable amount of an assets on a systematic basis over its useful life. However, Nepal Accounting Standard (NAS) suggests three method to depreciate assets on systematic basis namely: Straight Line Method, Diminishing Balance Method and Units of Production Method. The entity shall select the method that most closely reflects, the expected pattern of consumption of the asset embodying economic benefit. [Source: Nepal Accounting Standard (NAS)]

What is Diminishing Balance Method?
Diminishing Balance Method results in a decreasing charge of depreciation over assets’ useful life. More depreciation is charged in first year and the depreciation charge gradually decreases with time. It is more scientific method of depreciation to those organization other than specialized nature because we can derive more benefit from the assets in the initial period than later. Similarly, Straight line method depreciates depreciable value (cost less estimated salvage value) evenly throughout the useful life of the fixed asset.  Under the units-of-production method, useful life of the asset is expressed in terms of the total number of units expected to be produced and calculate depreciation amount based on the production units.

Scenario of Nepal
Most of the Nepalese organization adopt Diminishing Balance Method for calculation of the depreciation amount of the assets trying to make it in line with Income Tax Act, 2058. Income Tax Act also adopts modified version of Diminishing Balance Method. However, those organizations forget to compare the treatment about disposal of assets. As per Income Tax Act, total disposal proceeds of assets shall be deducted from the written down value of assets. However, accounting standards do not allow to deduct such total proceeds. Profit or Loss of each assets shall be immediately calculated and treat in account at the time of sale. If we treat assets disposal as per general accounting practice or NAS, closing value of assets will be different and depreciation amount as per income tax act and accounting practice will be different definitely.

Another reason to adopt depreciation method as per Income Tax Act is misconception about Deferred Tax and avoid calculating it and try to make the assets diminishing value in line with the Income Tax Act. However, adoption of Diminishing Balance Method does not always avoid calculation of Deferred Tax. Deferred tax shall be accounted for even after the use of Diminishing Balance Method of deprecation in case of disposal of assets due to different treatment of disposal of assets as per NAS and Income Tax Act. As per Income Tax assets are depreciated by grouping the assets into different group namely A, B, C, D and E and use the depreciation rate as per Income Tax Act, 2058, which is not as per principles of Nepal Accounting Standard (NAS). As per NAS, depreciation of assets shall be charged on each assets rather than by grouping the assets. In addition, depreciation rate shall be different based on the useful life, wear and tear and technical obsolescence and other related factors of individual assets.

If we adopt depreciation method as per Income Tax Act, assets are absorbed based on the time of purchase of fixed assets (full if purchased till Poush end, 2/3rd if purchased from Magh to Chaitra, 1/3rd if purchased from Baisakh to Ashad). Depreciation is charged on this absorbed amount only. Unabsorbed portion of assets shall be added in the opening balance of the assets of next year which mislead the closing balance of fixed assets. However, as per NAS, 100% of purchased amount shall be capitalized and depreciation shall be calculated on such capitalized amount from the date of ready to use of that assets.

What is the Problem?
The main problem is the concept of adoption of Diminishing Balance Method. Calculation of Depreciation based on grouping of assets, using flat rate of depreciation, non-estimation of residual value are the major problems in application of Diminishing Balance Method. As per NAS, each assets shall be depreciated separately by estimating its using pattern, residual value etc. However, based on my working experience in Nepal, I conclude that, most of the organizations do not determine depreciation rate based on the residual value and expected life of assets. The following formula shall be used to find the correct rate of depreciation.
Rate of Depreciation= 1-(Residual Value/cost of assets) 1/years
For Example: If the assets having cost price NRs. 100,000 has 5 years useful life with residual value NRs. 10,000. Then Rate of Depreciation will be
= 36.90% per annum
For above problem, annual depreciation rate of 36.90 % shall be used to calculate the depreciation amount, until the estimation regarding the consumption of the assets of the organization changes.

Hence, the application of depreciation method adopted by Nepalese organizations is wrong. Most of the organization are using depreciation rate as per Income Tax Act not based on the estimation of consumption of assets and systematic calculation of depreciation rate. So, Nepal Accounting Standards (NAS) are not adopted by the Nepalese organization correctly.

Interesting Fact
From the above discussion, we can conclude that most of the Nepalese organizations are adopting wrong depreciation practice. But the interesting fact about this issue is that neither of the independent auditors issue their audit report by qualifying their opinion based on this fact (Reports are qualified based on other reasons but not about the wrong application of Depreciation Method) even though it gives material effect in the Financial Statements and is contrary to Nepal Accounting Standard (NAS).