Historically companies applied the SARS rates for wear and tear to their assets and used this as the accounting depreciation charge. This avoided the need for deferred tax (being the accounting entry for the tax effect on the difference between the SARS wear and tear rates and the accounting depreciation). Although this simplifies matters it is incorrect in terms of the Accounting Standards. In fact it can often lead to material differences and audit qualifications for non-compliance with the standard.
The general concept to create the correct accounting treatment is to consider the residual values and useful lives of each asset. The depreciable amount is the cost of the asset less its residual value. The depreciation is the systematic allocation of the depreciable amount over its useful life.
Residual value is the estimated amount you would currently obtain from disposal of the asset. It is the current price of the asset as if it were of the age and condition at the end of its expected useful life.
The useful life is the period over which the asset is expected to be available for use by the entity.
So for example an entity purchasing a motor vehicle would consider the period they intend keeping the vehicles (say 4 years). Should they have the same 4 year old vehicle for sale now, they would be able to recover approximately R X amount (residual value). The depreciation will be the cost less R X (residual value) divided over 4 years.
This concept in especially important when depreciating plant and machinery, as these assets generally will be in use for many years and certainly will have a residual value.
By not applying accounting standards to big classes of assets the potential depreciation error could be material (differences have a cumulative effect over the years on materiality), and the significance of non-compliance to the accounting standards could result in audit qualification.
Despite the administrative burden, the concept of depreciating in this manner does result in a fair charge to the income statement that reflects the consumption of the asset over its useful life. The financial records are more meaningful as a result.
There are further issues in the accounting standard regarding recognition of cost, fair value, impairment, revaluation, componentisation etc. which have not been discussed in this article. This is only a high level summary for general awareness purposes.
Author: Liza Wood | Audit Director
This article is a general information sheet and should not be used or relied upon as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your financial adviser for specific and detailed advice. Errors and omissions excepted (E&OE)