Do you work in the production company? And did you find out that some of your production assets are still in operation but they were fully depreciated?
In this case, the original estimate of machinery’s useful life proved to be incorrect.
The problem is that as these machines are used beyond their useful life, they are fully depreciated and their carrying amount is zero.
But in this case, what depreciation expense can you recognise in the profit or loss?
None, of course – because the carrying amount of your property, plant and equipment cannot decrease below zero.
So in fact, you use the machines, but you can’t really recognise any depreciation expense because there’s nothing left. You have fully depreciated these assets in the previous reporting periods.
And as a result, the matching principle does not work here. The expenses simply do not match the benefits gained from these machines.
The problem is in the machines’ useful lives
The standard Ind AS 16 Property, Plant and Equipment defines the useful life as either:
It is not the potential or economic life of the asset. These two will often not be the same!
For example, the normal economic life of a car is 4 years, but the company’s policy is to renew car park every 2 years. In this case, car’s useful life is just 2 years.
Or, the economic life of a machine is 6 years, but after 3 years, the company’s experts assess that the machine can be used for another 5 years. In this case, total useful life is 8 years.
Now, this is extremely important: Standard IndAS 16 requires entities to review assets’ useful lives at least at each financial year-end.
You would not believe how many entities simply forget it!
They just book the annual depreciation charge based on the rates determined for some group of assets and that’s it.
They do not revise the useful lives of their assets and as a result, they end up with using fully depreciated assets in the production process.
How to fix this situation?
Review useful lives at each financial year-end.
Useful life is an accounting estimate and if you find out that it is different from what you initially set, you need to book this change in line with the standard IndAS 8 Accounting Policies, Changes in Accounting Estimates and Errors.
It means that you simply set the new remaining useful life, take the carrying amount and recognise the depreciation charge based on the carrying amount and new remaining useful life.
No restatement of previous periods’ financial statements is permitted. IndAS 8 requires recognising the change in accounting estimates prospectively (now and in the future).
Now you might say: OK Rajendra, I got it, but what should I do when the carrying amount (net book value) of my assets is zero?
Well, it depends.
If you reviewed the useful lives in the past regularly and during the current reporting period you find out that you’d like to use the assets even longer, then there’s not much to do. Just leave these assets as they are and make sure you avoid this situation in the future.
However, if you really forgot to revise the useful lives in the previous reporting period, this failure to apply IndAS 16 results in the accounting error.
If this error is material, then you should correct it retrospectively in line with Ind AS 8. It means restating the previous periods using the revised estimated useful lives. A Huge amount of work!