The assessment of depreciation and the amount to be charged in respect thereof in an accounting period are usually based on the following three factors :
- historical cost or other amount substituted for the historical cost of the depreciable asset when the asset has been revalued;
- expected useful life of the depreciable asset; and
- estimated residual value of the depreciable asset.
The useful life of a depreciable asset is shorter than its physical life and is:
- pre-determined legal or contractual limits, such as the expiry dates of related leases;
- directly governed extraction or consumption;
- dependent on the extent of use and physical deterioration on account of wear and tear which again depends on operational factors, such as, the number of shifts for which the asset is to be used, repair and maintenance policy of the enterprise, etc; and
- reduced obsolescence arising from such factors as :
- technological changes;
- improvement in production methods;
- change in market demand for the product or service output of the asset; or
- legal or other restrictions.
Determination of the useful life of a depreciable asset is a matter of estimation and is normally based on various factors including experience with similar types of assets. Such estimation is more difficult for an asset using new technology or used in the production of a new product or in the provision of a new service but is nevertheless required on some reasonable basis. Determination of residual value of an asset is normally a difficult matter. If such value is considered as insignificant, it is normally regarded as nil. On the contrary, if the residual value is likely to be significant, it is estimated at the time of acquisition/installation, or at the time of subsequent revaluation of the asset. One of the bases for determining the residual value would be the realisable value of similar assets which have reached the end of their useful lives and have operated under conditions similar to those in which the asset will be used.
The quantum of depreciation to be provided in an accounting period involves the exercise of judgement management in the light of technical, commercial, accounting and legal requirements and accordingly may need periodical review. If it is considered that the original estimate of useful life of an asset requires any revision, the unamortised depreciable amount of the asset is charged to revenue over the revised remaining useful life. The useful lives of major depreciable assets or class of depreciable assets may be reviewed periodically. Where there is revision of estimated useful life of an asset, the unamortised depreciation amount should be charged over the remaining useful life too. An entity may adopt different types of methods of depreciation for different types of assets provided the same are adopted on a consistent basis. Even a company having plants at different locations may adopt different method of depreciation in the same accounting year. Further, it may be noted that the depreciation would be charged on pro-rata basis in respect of assets acquired during the financial year.