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.

 
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.

Example

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 divide 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.

Example
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.

Note:

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.

Example

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.

Example

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)
= $8,225

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.
Note:

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.