When a firm acquires a physical asset such as machinery or motor vehicle, their future value will likely deteriorate due to wear and tear, market conditions, or obsolescence, as with some IT software that is no longer useful [1]. As a result, many assets will have finite, i.e., limited, useful lives because they cannot last forever. This process is referred to as depreciation, which is a specific accounting term described as the recording of an expense to represent the loss of value in a wasting asset over a period…[2]. In the case of intangible items (e.g., software or computer program, patent, trademark or a license, etc.), the term amortisation is used instead.
MacLaney and Atrill (2020) suggest that to calculate the depreciation of a non-current asset that has been depleted in revenue-generating activities, the following must be considered:
the cost (or fair value) of the asset;
the useful life of the asset;
the residual value of the asset;
the depreciation method.
The cost of the asset
Depreciation of an asset begins when it is available for use. Therefore, the cost of an asset should include all the costs incurred by an entity to bring the asset into use, e.g., installation or delivery costs may be added up to the purchase price, if applicable. Other examples of additional costs may include legal fees as in the case of purchasing property or land. In addition, MacLaney and Atrill (2020) suggest that any costs incurred in improving or altering an asset to make it suitable for use will also be included as part of the total cost.
However, a non-current (fixed) asset can be recorded at a fair value rather than its historic cost (the cost of purchase plus any additional costs), provided the fair value of the asset can be measured reliably. Fair values are market-based measurements and can be described as the selling price that could be obtained in an orderly transaction under market conditions [3]. Therefore, if fair values were applied, the depreciation expense should be based on those fair values.
The useful life of the asset
The depreciable amount of an asset shall be allocated on a systematic basis over its useful life [p50, IAS 16]. According to Alexander and Nobes (2020), the life in question refers to the useful economic life [4]. In addition, Atrill and MacLaney (2019) distinguished between the economic life and physical life of an asset. Technological progress will be likely to determine the economic life of an asset, while the physical life will be decided by the wear and tear and/or the passage of time. An asset’s economic life can possibly be shorter than its physical. For example, a piece of machinery or computer may have a physical life of nine years and economic life of four years. This scenario might occur if such a computer is no longer able to compete with newer assets, and therefore cannot bring any more economic value to the company’s owners.
That is why the economic life determines the expected useful life of an asset. However, due to rapid technological changes, it may not always be easy to accurately establish the life span of the asset’s economic usefulness.
Residual value
The residual value, or disposal value of an asset, is an important measure used in determining the total amount allocated for depreciation, as explained later in this article (‘Depreciation method’). When a business decides to dispose of an asset that may still be of value to others, some payment may be received [5]. This payment is known as the residual value of an asset. For accounting purposes, the residual value is subtracted from the cost (or fair) value of an asset.
Depreciation is recognised even if the fair value of the asset exceeds its
carrying amount, as long as the asset’s residual value does not exceed its
carrying amount*. Repair and maintenance of an asset do not negate the need to depreciate it.
paragraph 52: IAS 16 Property, Plant and Equipment
*carrying amount can be defined as the total value of an asset (based on historic cost or fair value) less the accumulated depreciation charges to date.
According to the International Accounting Standard (IAS) 16 Property, Plant and Equipment, the residual value and asset's useful life must be reviewed at least at each financial year-end. Therefore, if expectations differ from previous estimates, the change(s) should be accounted for as a change in an accounting estimate under IAS 8 Accounting Policies, Changes in Accounting Estimates, and Errors.
Depreciation method
The depreciation method should reflect the pattern in which the asset’s future economic benefits are expected to be consumed by the entity. Although there are many ways a depreciation amount can be established, two standard methods are used by businesses in practice. The first of these is called the straight-line method.
Using the straight-line depreciation method, the value of an asset is equally reduced over each reporting period until it reaches its residual value. Atrill and MacLaney (2019) define it with the following passage: ‘‘this method simply allocates the amount to be depreciated evenly over the useful life of the asset. In other words, there is an equal depreciation expense for each year that the asset is held’’.
To best understand the straight-line method is to use an appropriate example. Case Study 1 provides a clear illustration of how this method is used in practice.
Case Study 1
Pegasus Ltd is a small fictional company that provides delivery services. A firm has recently acquired ten identical brand-new cars to increase the amount of deliveries they can provide. Now, a firm’s Chief Financial Officer was asked by the owner to calculate the depreciation expense for each reporting year. Consider the following information:
Cost of car: $21,300
Estimated residual value: $1,000
Estimated useful life: 10 years
As mentioned before, the total amount to be depreciated must be calculated in order to obtain a yearly depreciation charge. That is, the total cost (for the purpose of this exercise, we use the purchase price of $20,000, i.e., historic cost plus additional costs incurred by the company to make a car ready for use) less the residual value, i.e., $21,300 – $1,000 = $20,300. At this stage, the annual depreciation expense is calculated by dividing the amount to be depreciated ($20,300) by the estimated car’s useful life of ten years.
$20,300 / 10 = $2,030
This means that the depreciation charge of £2,030 for one car will be initially deducted from the total cost of $21,300, and it will continue each year until it reaches the residual value in ten years. Thus, the amount of depreciation will be accumulated for as long the company owns the asset. For the purposes of this exercise, we assume a firm’s management will not dispose of the asset until it reaches its expected useful life.
The straight-line method derives its name from the fact, that the net book value of an asset at the end of each reporting year, when plotted against time, will result in straight line, as shown in Figure 1 below.
Figure 1. The straight-line method. Retrieved from https://www.calculatestuff.com/business/straight-line-depreciation-calculator?purchase_price=21300.00&residual_value=1000.00&useful_life=10&placed_in_service=05-2021
The other approach to calculating the depreciation expense is called the reducing-balance method. Under this method, a fixed percentage rate of depreciation will be applied to the carrying amount of the asset each year. Deriving the fixed percentage to be applied requires the use of the following formula [6]:
Case Study 2
Using the same scenario from Case Study 1 and the formula, we can then derive the depreciation rate of 28%. The reducing balance method assumes that more of the asset is used up in the first period than the next and so on. It is calculated by applying a fixed percentage to the reducing balance of the asset [7].
Figure 2.
The reducing balance at the end of Year 10 should equate to the residual value ($1,000). In our case, it did not because the figures used were rounded to simplify and ease the calculations. Nonetheless, we can see that the carrying amount of $1,109 was still greater at the end of Year 9 than the residual value, therefore reassuring us of our calculations. It is noticeable that the pattern of the reducing balance method is quite different from the straight-line approach. We can see that in Year 1 the depreciation expense was the highest, and then gradually declined every year, e.g., $5,964 > $4,294 > $3,091 > $2,226 > ... $430 > $310.
The calculations in Figure 2 can be time-consuming, especially if the expected useful life is lengthy, e.g., 50 years. Therefore, instead of manually calculating the carrying amount year by year, the following formula can be applied:
Understanding the deprecation expense
The depreciation expense along with other charges (e.g., amortisation or impairment costs) must be deducted from a firm’s operating profit and be reported on the company’s income statement. However, since the depreciation is a non-cash expense, its value would be added back to its cash flow statement. This process can be explained by the fact that non-current assets are used for revenue-generating purposes. For that reason, depreciation charges must be included in profit and loss accounts for the relevant reporting period to enhance the quality of measuring a company’s financial performance.
Different companies can choose various depreciation methods, including the less popular method called the units of production, which we have not covered in this article. Once a method has been chosen, it should be applied from period to period unless there is a change in the expected pattern of consumption of those future economic benefits. For example, Atrill and MacLaney (2019) suggest that the straight-line method is usually applied where the economic benefits are consumed evenly over time, for instance, with buildings. In contrast, the reducing-balance method may be more appropriate where the economic benefits from the asset’s usage decline over time, e.g., with certain types of machinery that lose their efficiency.
Finally, calculating the depreciation expense include areas where some subjective judgment is required. For example, the expected useful life of a vehicle is not an exact science, and no one could argue the exact life span of its usefulness. Besides, determining the residual value of an asset may also prove to be challenging, since we do not know precisely if, say, a company will be able to sell its car for $1,000 after its expected useful life of 10 years, as shown in this article (Case Study 1 & 2).
References
[1] McLaney, E., Atrill, P. (2020). Accounting and Finance: An Introduction. 10th ed. [ebook] Pearson. Available at: https://www.perlego.com/book/1356521/
[2] Moles, P., Terry, N. (1997). The Handbook of International Financial Terms. Oxford University Press.
[3] Atrill, P., McLaney, E. (2019). Financial Accounting for Decision Makers. 9th ed. [ebook] Pearson. Available at: https://www.perlego.com/book/955158/
[4] Alexander, D., Nobes, C. (2020). Financial Accounting. 7th ed. [ebook] Pearson. Available at: https://www.perlego.com/book/1356528/
[5] [6] Atrill, P., McLaney, E. (2018). Accounting and Finance for Non-Specialists. 11th ed. [ebook] Pearson. Available at: https://www.perlego.com/book/859641/
[7] Britton, A., Waterston, C. (2011). Financial Accounting. 5th ed. [ebook] Pearson. Available at: https://www.perlego.com/book/810801/