Depreciation is designed to spread an asset’s cost over its entire useful service life. Its service life is the period over which it is worn out for any reason, at the end of which it is no longer usable, or not usable without extensive overhaul. Its useful life can also be considered terminated at the point when it no longer has a sufficient productive capacity for ongoing company production needs, rendering it essentially obsolete. Anything can be depreciated that has a business purpose, has a productive life of more than one year, gradually wears out over time, and whose cost exceeds the corporate capitalization limit. Since land does not wear out, it cannot be depreciated. If an asset is present but is temporarily idle, its depreciation should be continued using the existing assumptions for the usable life of the asset. Only if it is permanently idled should the accountant review the need to recognize impairment of the asset.
An asset is rarely purchased or sold precisely on the first or last day of the fiscal year, which brings up the issue of how depreciation is to be calculated in these first and last partial years of use. One option is to record a full year of depreciation in the year of acquisition and no depreciation in the year of sale. Another option is to record a half-year of depreciation in the first year and a half-year of depreciation in the last year. One can also prorate the depreciation more precisely, making it accurate to within the nearest month (or even the nearest day) of when an acquisition or sale transaction occurs.
IAS 16 states that the depreciation method should reflect the pattern in which the asset’s future economic benefits are expected to be consumed by the entity and that appropriateness of the method should be reviewed at least annually in case there has been a change in the expected pattern. Beyond that, the standard leaves the choice of method to the entity, even though it does cite straight-line, diminishing balance, and units of production methods.
This post describe depreciation methods of fixed asset (PP&E). Adapted from IAS 16. It comes with case examples. Enjoy!
Asset’s Depreciation Basis Calculated
The basis used for an asset when conducting a depreciation calculation should be its capitalized cost less any salvage value that the company expects to receive at the time when the asset is expected to be taken out of active use. The salvage value can be difficult to determine, for several reasons.
- Removal costs – There may be a removal cost associated with the asset, which will reduce the net salvage value that will be realized. If the equipment is especially large or involves environmental hazards, the removal cost may exceed the salvage value. In this latter instance, the salvage value may be negative, in which case it should be ignored for depreciation purposes.
- Obsolescence – Asset obsolescence is so rapid in some industries that a reasonable appraisal of salvage value at the time an asset is put into service may require drastic revision shortly thereafter.
- No market – There may be no ready market for the sale of used assets.
- Appraisal cost – The cost of conducting an appraisal in order to determine a net salvage value may be excessive in relation to the cost of the equipment being appraised.
Consequently, it may be necessary to make regular revisions to a salvage value estimate in order to reflect the ongoing realities of asset resale values. In the case of low-cost assets, it is rarely worth the effort to derive salvage values for depreciation purposes; as a result, these items are typically fully depreciated on the assumption that they have no salvage value.
Straight-Line Depreciation Method [SL]
The straight-line depreciation method is the simplest method available and is the most popular one when a company has no need to recognize depreciation costs at an accelerated rate. It is also used for all amortization calculations. The straight-line method is calculated by subtracting an asset’s expected salvage value from its capitalized cost and then dividing this amount by the estimated life of the asset.
A machine has a cost of $40,000 and an expected salvage value of $8,000. It is expected to be in service for eight years. Given these assumptions, its annual depreciation expense is:
Depreciation = (Cost – salvage value) / Number of years in service
Depreciation = ($40,000 – $8,000) / 8 years
Depreciation = $32,000 / 8 years
Depreciation = $4,000 per year
Note: For depreciation per month, simply devide 12.
Double-Declining Balance Depreciation Method [DDB]
The double-declining balance (DDB) method is the most aggressive depreciation method for recognizing the bulk of the expense toward the beginning of an asset’s useful life. To calculate it, determine the straight-line depreciation for an asset for its first year. Then double this amount, which yields the depreciation for the first year. Then subtract the first-year depreciation from the asset cost (using no salvage value deduction), and run the same calculation again for the next year. Continue to use this methodology for the useful life of the asset.
A machine costing $20,000 is estimated to have a useful life of six years. Under the straightline method, it would have depreciation of $3,333 per year. Consequently, the first year of depreciation under the 200% DDB method would be double that amount, or $6,667. The calculation for all six years of depreciation is noted in the next table.
In the example that there is still some cost left at the end of the sixth year that has not been depreciated. This is usually handled by converting over from the DDB method to the straight-line method in the year in which the straight-line method would result in a higher amount of depreciation; the straight-line method is used until all of the available depreciation has been recognized.
Sum-of-the-Years’ Digits Depreciation Method
This depreciation method recognizes the bulk of all depreciation within the first few years of an asset’s depreciable period but does not do so quite as rapidly as the double declining balance method. Its calculation can be surmised from its name. For the first year of depreciation, add up the number of years over which an asset is scheduled to be depreciated and divide this into the total number of years remaining. The resulting percentage is used as the depreciation rate. In succeeding years, simply divide the reduced number of years left into the same total number of years remaining.
A punch press costing $24,000 is scheduled to be depreciated over five years. The sum of the years’ digits is 15 (Year 1 + Year 2 + Year 3 + Year 4 + Year 5). The depreciation calculation in each of the five years is:
Year 1 = (5/15) x $24,000 = $8,000
Year 2 = (4/15) x $24,000 = $6,400
Year 3 = (3/15) x $24,000 = $4,800
Year 4 = (2/15) x $24,000 = $3,200
Year 5 = (1/15) x $24,000 = $1,600
Total = $24,000
Units-of-Production Depreciation Method
The units-of-production depreciation method can result in the most accurate matching of actual asset usage to the related amount of depreciation that is recognized in the accounting records. Its use is limited to those assets to which some estimate of production can be attached.
To calculate it, first estimate the total number of units of production that are likely to result from the use of an asset. Then divide the total capitalized asset cost (less salvage value, if this is known) by the total estimated production to arrive at the depreciation cost per unit of production. Then derive the depreciation recognized by multiplying the number of units of actual production during the period by the depreciation cost per unit.
An oil derrick is constructed at a cost of $350,000. It is expected to be used in the extraction of 1,000,000 barrels of oil, which results in an anticipated depreciation rate of $0.35 per barrel. During the first month, 23,500 barrels of oil are extracted. Under this method, the resulting depreciation cost is:
= (cost per unit of production) x (number of units of production)
= ($0.35 per barrel) x (23,500 barrels)
This calculation can also be used with service hours as its basis rather than units of production. When used in this manner, the method can be applied to a larger number of assets for which production volumes would not otherwise be available.
If there is a significant divergence of actual production activity from the original estimate, the depreciation cost per unit of production can be altered from time to time to reflect the realities of actual production volumes.
Cost Model versus Revaluation Model
IAS 16 provides for two acceptable alternative approaches to accounting for long-lived tangible assets. The first of these is the cost model, under which an item of PP&E is carried at its cost net of any accumulated depreciation and any accumulated impairment losses.
In many jurisdictions this is the only method permitted by statute; however, a number of jurisdictions, particularly those with significant rates of inflation, do permit either full or selective revaluation. IAS 16 acknowledges this fact by also mandating what it calls the “revaluation model.”
Using the revaluation model, an item of PP&E whose fair value can be measured reliably is carried at a revalued amount, which is its fair value at the date of the revaluation net of any subsequent accumulated depreciation and accumulated impairment losses. IAS 16 requires that revaluations be made with sufficient regularity to ensure that the carrying amount does not differ materially from that which would be determined using fair value at the date of the statement of financial position. If an item of PP&E is revalued, the entire class of the assets to which that item belongs has to be revalued.
The fair value of land and buildings should be appraised professionally based on the market; similarly, the fair value of items of plant and equipment is also determined by appraisal. IAS 16 states that if there is no market-based evidence of fair value because of the specialized nature of the item, an entity may need to estimate fair value using an income or a depreciated replacement cost approach.
Example: Depreciated Replacement Cost (sound value) as a Valuation Approach
An asset acquired January 1, 2004, at a cost of €40,000 was expected to have a useful economic life of 10 years. On January 1, 2007, it is appraised as having a gross replacement cost of €50,000. The sound value, or depreciated replacement cost, would be 7/10 × €50,000, or €35,000. This compares with a book, or carrying, value of €28,000 at that same date. Mechanically, to accomplish a revaluation at January1, 2006, the asset should be written up by €10,000 (i.e., from €40,000 to €50,000 gross cost) and the accumulated depreciation should be proportionally written up by €3,000 (from €12,000 to €15,000). Under IAS 16, the net amount of the revaluation adjustment, €7,000, would be credited to revaluation surplus, and reported in other comprehensive income.
An alternative accounting procedure is also permitted under the standard, whereby accumulated depreciation at the date of the revaluation is written off against the gross carrying value of the asset. In the previous example, this would mean that the €12,000 of accumulated depreciation at January 1, 2006, immediately prior to the revaluation, would be credited to the gross asset amount, €40,000, thereby reducing it to €28,000. Then the asset account would be adjusted to reflect the valuation of €35,000 by increasing the asset account by €7,000 (€35,000 – €28,000), with the offset again in other comprehensive income. In terms of total assets reported in the statement of financial position, this has exactly the same effect as the first method.
Nevertheless, many users of financial statements, including credit grantors and prospective investors, pay heed to the ratio of net property and equipment as a fraction of the related gross amounts. This is done to assess the relative age of the enterprise’s productive assets and, indirectly, to estimate the timing and amounts of cash needed for asset replacements. There is a significant diminution of information under the second method. Accordingly, the first approach described, preserving the relationship between gross and net asset amounts after the revaluation, is recommended as being the preferable alternative if the goal is meaningful financial reporting.
Although IAS 16 requires revaluation of all assets in a given class, the Standard recognizes that it may be more practical to accomplish this on a rolling, or cycle, basis. This could be done by revaluing one-third of the assets in a given asset category (such as machinery) in each year, so that as of the date of any statement of financial position, one-third of the group is valued at current fair value, another one third is valued at amounts that are one year obsolete, and another one-third are valued at amounts that are two years obsolete. Unless values are changing rapidly, it is likely that the statement of financial position would not be materially distorted. Therefore, this approach would be a reasonable means to facilitate the revaluation process.
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