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.
The Internal Revenue Service issues guidelines for the depreciable lifetime of familiar fixed assets, such as generators and trucks. The straight-line method divides the lifetime into the asset’s net cost — purchase price less salvage value — and uses the quotient as the annual depreciation expense. Accelerated depreciation methods, such as double declining balance and sum of the years’ digits, use different formulas to front-load depreciation expenses in the early years. Relative to straight line depreciation, accelerated depreciation reduces taxable income faster in the asset’s early years.
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. Statement 154 of the U.S. Financial Accounting Standards Board describes this as a change in the accounting estimate for the asset’s depreciation, which in turn signals a change in accounting principle for the company. The change of accounting estimate alters the pace at which depreciation accumulates and thus affects the carrying value of asset — purchase cost less accumulated depreciation — on the balance sheet over time.
You normally must file IRS Form 3115, Application for Change in Accounting Method, before switching the depreciation method you apply to a fixed asset. You must include a justification for your action and any supporting documents. Under certain circumstances, the IRS allows you to combine multiple assets in a single filing of Form 3115. The IRS will notify you of their decision to accept or reject your request. You must also post a footnote in your annual report announcing the change in depreciation method and the reason for making the change.
FAS 154 states that you do not need to make retroactive revisions because of a change to an accounting estimate such as depreciation. You simply adopt the new method in the current year and carry it forward through the remaining life of the fixed asset. This saves the work of restating previous years’ balance sheets and income statements to reflect the change. You are most likely to request a change to a depreciation method because you revise the estimated future benefits afforded by the asset or gain more information about the consumption pattern of the asset. A fixed asset’s carrying value bears no necessary relationship to its market value.
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