IAS 16 (of the IFRS) provides for two acceptable alternative approaches to accounting for fixed assets. The first of these is the cost model, under which an item of fixed asset is carried at its cost minus its accumulated depreciation. “So, how do I calculate fixed assets depreciation under the IFRS?” you may ask.
Before answering the question, let’s first have a look at what depreciation is, according to IFRS.
Depreciation under the IAS 16
Simply put. A company uses fixed asset (also known as “property, plant and equipment” abbreviated as “PP&E”) to run its business. Since they’re used overtime, the function of the fixed assets got declined as well as their value. The declined value (of the fixed asset) is called “depreciation”.
IAS 16 describes depreciation as,
“Both the decline in value of an asset over time as well as the systematic allocation of the depreciable amount of an asset over its useful life.”
Another way to see depreciation that, it is designed to spread an asset’s cost over its entire useful service life. At the end of the service life, the asset is no longer expected to be economically usable, or when it no longer has a sufficient productive capacity for ongoing company production needs, thus rendering it essentially obsolete.
Note: The ‘service life’ is the period of time over which the product is anticipated to be used, after which it is expected to have been worn out).
“What can I depreciate?” you may ask further.
You can, literally, depreciate anything 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.
Note: Since land does not wear out, it cannot be depreciated.
Here are some terms and definitions that will be happily used in this post (Source: IAS 16):
- Depreciable amount – Cost of an asset, or another amount that has been substituted for cost, minus the residual value of the asset.
- Residual value – Estimated amount of what the entity would currently obtain upon disposal of the asset, net of estimated costs of disposal, if the asset were already of the age and in the condition expected at the end of its useful life.
- Useful life – Period over which an asset is expected to be available for use by an entity; or the number of production, or similar units, expected to be obtained from the asset by an entity.
- Cost – Amount of cash or cash equivalent paid, the fair value of the other consideration given to acquire an asset at the time of its acquisition or construction, or (where applicable) the amount attributed to that asset when initially recognized in accordance with the specific requirements of other IFRS—for example, IFRS 2, Share-Based Payment.
How To Calculate Fixed Assets Depreciation Based on IFRS
There are several methods you can choose alternative ways to calculate depreciation. IAS 16, however, 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.
Straight-line depreciation provides for a depreciation rate that is the same amount in every year of an asset’s life, whereas diminishing balance depreciation methods are oriented toward the more rapid recognition of depreciation expenses, on the grounds that an asset is used most intensively when it is first acquired.
There are, also, depreciation methods based on compound interest factors, resulting in delayed depreciation recognition. But, since these methods are rarely used, however, they are not presented here.
Perhaps the most accurate depreciation methods are those that are tied to actual asset usage (such as the units of production method), though they require much more extensive recordkeeping in relation to units of usage.
Below are rules you should consider, in calculating fixed assets depreciation based on IFRS:
If an asset is present but is temporarily idle, then 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.
Please note, however, that 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. Although IAS 16 does not go to such detail, one would need to be aware of this:
When an asset is either acquired or disposed of during the year, the full-year depreciation calculation should be prorated between the accounting periods involved. This is necessary to achieve proper matching.
It may so happen that individual assets in a relatively homogeneous group are regularly acquired and disposed of; in this case, there are a number of alternatives available, all of which are valid as long as they are consistently applied.
One option is to record a full year of depreciation in the year of acquisition and no depreciation in the year of sale. It is also possible to record a half-year of depreciation in the first year and a half-year of depreciation in the last year. One can even 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.
Next, let’s have a look at methods available to depreciate fixed assets…
Using Straight-Line Depreciation Method
This is the simplest method available, and is the most popular one when a company has no particular need to recognize depreciation costs at an accelerated rate (as would be the case when it wants to match the book value of its depreciation to the accelerated depreciation used for income tax calculation purposes), and it is used for all amortization calculations.
This method is calculated by subtracting an asset’s expected residual value from its capitalized cost and then dividing this amount by the estimated useful life of the asset.
A machine has a cost of $40,000 and an expected residual value of $8,000. It is expected to be in service for eight years. Given these assumptions, its annual depreciation expense is:
= (Cost – residual value) / number of years in service
= ($40,000 – $8,000) / 8 years
= $32,000 / 8 years
= $4,000 depreciation per year
Remember: “cost”, in general, could be the amount of cash or cash equivalent paid; or the fair value of the other consideration given to acquire an asset at the time of its acquisition or construction; or the amount attributed to that asset when initially recognized.
Using Accelerated Depreciation Methods
In brief, using this method, the depreciation expense is higher in the early years of the asset’s useful life and lower in the later years.
IAS 16 mentions only one accelerated method, the diminishing balance method, but other methods have been employed in various national GAAP under earlier or contemporary accounting standards. Let’s have a look one-by-one
1. Diminishing balance – the depreciation rate is applied to the net book value of the asset, resulting in a diminishing annual charge. There are various ways to compute the percentage to be applied. The next formula provides a mathematically correct allocation over useful life.
where n = the expected useful life in years.
A machine costing $20,000 is estimated to have a residual value of $1,000, and a useful life of four years. The depreciation rate under the diminishing balance, applying the preceding formula, is approximately 44%. Consequently, the depreciation expense during each of the four years is:
Year 1 = 44% × $10,000 =$4,400
Year 2 = 44% × $5,600 = $2,464
Year 3 = 44% × $3,136 = $1,380
Year 4 = $10,000 – $4,400 – $2,464 – $1,380 – $1,000 = $756
However, companies generally use approximations or conventions influenced by tax practice, such as a multiple of the straight-line rate times the net carrying value at the beginning of the year.
Straight-line rate = 1/Estimated useful life
A machine costing $20,000 is estimated to have a useful life of six years. Under the straight-line 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 below:
Note 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; then the straight-line method is used until all of the available depreciation has been recognized.
2. Sum-of-the-years’ digits method – This is another method to accomplish a diminishing charge for depreciation is the sum-of-the-years’ digits method—which is commonly used in the United States and certain other venues.
Sum-of-the-years’ digits (SYD) depreciation = Cost less salvage value × Applicable fraction
‘Applicable fraction’ = (number of years of estimated life remaining as of the beginning of the year) / SYD
SYD = [n(n + 1)] / 2
n = estimated useful life
This depreciation method is designed to recognize 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 described previously.
Its calculation can be surmised from its name. For the first year of depreciation, one adds up the number of years over which an asset is scheduled to be depreciated and then divides 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 tool 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) × $24,000 = $ 8,000
Year 2 = (4/15) × $24,000 = $ 6,400
Year 3 = (3/15) × $24,000 = $ 4,800
Year 4 = (2/15) × $24,000 = $ 3,200
Year 5 = (1/15) × $24,000 = $ 1,600
Accum. Deprec = $24,000
In practice, unless there are tax-reasons to employ accelerated methods, large companies tend to use straight-line depreciation. This has the merit that it is simple to apply, and where a company has a large pool of similar assets, some of which are replaced each year, the aggregate annual depreciation charge is likely to be the same, irrespective of the method chosen.
Using 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 for which some estimate of production can be attached, but it is a particular favorite of those who use activity-based costing systems because it closely relates asset cost to actual activity.
To calculate it, 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 residual value, if this is known) by the total estimated production to arrive at the depreciation cost per unit of production.
The recognized depreciation is derived by multiplying the number of units of actual production during the period by the depreciation cost per unit. If there is a significant divergence of actual production activity from the original estimate, the depreciation cost per unit of production can be altered to reflect the realities of actual production volumes.
A machine, at an oil company, is assembled at a cost of $350,000. It is expected to be used in the extraction of 1 million 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. Using this method, the depreciation cost is counted as follows:
= (Cost per unit of production) × (Number of units of production)
= ($0.35 per barrel) × (23,500 barrels)
This calculation also can 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 be otherwise available.
The Challenge of Determining Residual Value (and the solution)
As you should do it on the useful life of an asset, the residual value should be reviewed at least at each financial year-end; if expectations differ from previous estimates, the change should be accounted for as a change in an accounting estimate.
However, the residual value can be difficult to determine, for several reasons:
- First, there may be a removal cost associated with the asset, which will reduce the net residual value that will be realized. If the equipment is especially large or if it involves environmental hazards, then the removal cost may exceed the residual value. In this latter instance, the residual value may be negative; in that case, it should be ignored for depreciation purposes.
- Second, the lack of a ready market for the sale of used assets in many instances.
- Finally, the cost of conducting an appraisal in order to determine a net residual value may be excessive in relation to the cost of the equipment being appraised.
For all these reasons, you should certainly attempt to set a net residual value in order to arrive at a cost base for depreciation purposes, but it will probably be necessary to make regular revisions in a cost-effective manner to reflect the ongoing realities of asset resale values. In the case of low-cost assets, it is rarely worth the effort to derive residual values for depreciation purposes; as a result, typically these items are fully depreciated on the assumption that they have no residual value.