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Change of Methods of Depreciation

Accounting policies and principles need to be consistently applied while recording the financial transactions. This is the Principle of Consistency. Any change in the method of depreciation implies a change in accounting estimate. Thus, there should be valid reasons for a change in method of depreciation. At the end of each financial year, management should review the method of depreciation. When there is a significant change in the pattern of the future economic benefits from the asset then the method of depreciation should also be changed. As per the Accounting Standard 1- Disclosure of Accounting Policies, the change in the method of depreciation is a change in the accounting estimate. Thus, it requires quantification and full disclosure in the footnotes. Also, the justification and financial effects of the change needs to be disclosed. Thus, the method of depreciation can be changed without retrospective effect or with retrospective effect. Without retrospective effect means no adjustment will be made for past entries and only in the future depreciation shall be charged by the new method. While with retrospective effect implies that the amount of depreciation to be charged is adjusted from the date of purchase of the asset. A company may decide to change the depreciation method it applies to a fixed asset. For example, if an asset loses much of its value early on, a company might switch from straight-line to accelerated depreciation. The choice among even these few methods, however, can have a significant effect on reported income. Without criteria for choosing among the alternatives, companies are almost completely unrestricted in their choice of method and they do choose different methods under apparently similar circumstances. It is also not uncommon for companies to change methods and thereby significantly change reported net income which also affects comparisons between periods. It is important that the method selected reflects economic reality. It is also important that the criteria for the choice be clearly understood so that the method be the same in all cases where the circumstances are the same. Depreciation is a mandatory charge. The management of a firm must select a depreciation method for income tax purposes and for financial accounting purposes. The firm needs not, however choose the same depreciation method for both income tax purposes and financial reporting purposes. In both cases, the selection is subject to constraints. For income tax purposes, the method must be one of these that are approved by Income Tax Rules. For financial accounting purposes, the method must be one that falls within the purview of generally accepted accounting principles (GAAP). Especially for Indian Company, for financial accounting purposes, the method is guided by the Companies Act 1956. So in both the cases, the selection of a suitable method is limited by law. If the firm selects same method of depreciation both for income tax accounting purposes and for financial accounting purposes, only one set of depreciation records need to be maintained and hence the cost of the accounting process will be lower. Despite this fact, some firms select to use approved depreciation method for income tax purposes and other method for financial accounting purposes.

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