Depreciation

Depreciation is the systematic allocation of the cost of an item of property, plant and equipment to the income statement over its useful life.

Why an item of property, plant and equipment (PPE) is recorded in the balance sheet instead of charging the cost of PPE as expense in the period in which that asset is acquired? The reason for this is the entity’s expectation of related economic benefits. As the related economic benefits are expected to be obtained in the next few years (over the useful life of PPE), therefore, to match the expenses with benefits, PPE is initially recorded as an asset, and is depreciated over its useful life. In other words, cost of an item of PPE is systematically allocated to the income statement as expense over its useful life.

For a large and complex item of PPE, it is possible that its major components have different useful lives. For example, body of a large ship has a useful life of 12 years, but its engine needs to be replaced after 4 years. In such cases, cost of that item of PPE is allocated to its major components and the major components are depreciated separately over their respective useful lives. In our example, body of the ship will be depreciated over 12 years, whereas engine of the ship will be depreciated over 4 years.

Methods of depreciation

There are several methods used to calculate depreciation, however, some of the commonly used methods of depreciation are listed below:

  • Straight-line method
  • Declining balance method (also known as reducing balance method
  • Machine hours method
  • Units of production method

Straight-line method of depreciation

Straight-line method of depreciation assumes that benefits from an item of PPE will be obtained uniformly throughout its useful life. To match the depreciation expense with relevant benefits, equal annual depreciation expense is charged in all years over the useful life of PPE.

Formula

Depreciation under straight line method can be calculated using any of the following formulae:

Depreciation expense = Depreciable amount / useful life

OR

Depreciation expense = Depreciable amount x depreciation rate

Let’s take a look at the following example to clarify straight line method of depreciation.

Example

On 1 July 20×1, XYZ Company purchased a refrigerator manufacturing plant costing $550,000 whose useful life is estimated to be 5 years. The plant’s salvage value or residual value is estimated to be $50,000. The company’s financial year is from January to December. Let’s see how depreciation expense is calculated using straight line method.

Depreciable amount is calculated by subtracting the salvage value from the cost of asset. In this case, depreciable amount is $500,000 ($550,000 – $50,000) which will be depreciated over the useful life of 5 years. Alternatively, depreciation rate can be calculated by taking the reciprocal of the asset’s useful life.  In this case, 1/5 gives us the depreciation rate of 20% per annum.

YearOpening NBVDepAcc depClosing NBV
20×1*550,00050,00050,000500,000
20×2500,000100,000150,000400,000
20×3400,000100,000250,000300,000
20×4300,000100,000350,000200,000
20×5200,000100,000450,000100,000
20×6100,00050,000500,00050,000
20×750,000500,00050,000

* In the first year, $550,000 represents the cost of plant which is purchased midway through the year. Depreciation expense of half year is charged in year 20×1, as the asset was available for use only for half year i.e. From 1 July 20×1 till 31 December 20×1.

Declining balance method of depreciation

Declining balance method is an accelerated depreciation method of depreciation which assumes that an item of PPE generates relatively larger benefits in its initial years compared to later years, and these benefits gradually decline over its useful life. To match the depreciation expense with relevant benefits, greater depreciation expense is charged in initial years compared to later years and depreciation expense gradually decreases over the useful life of PPE.

Formula

Following formula can be used to calculate depreciation under declining balance method:

Depreciation expense = Net book value x depreciation rate

Depreciation rate is determined based on the expected usage of the asset. It can be the same as calculated for the straight-line method i.e. 1/ useful life or this straight-line rate can be multiplied by any accelerator to arrive at the depreciation rate for declining balance method. For example, the straight-line rate can be multiplied by 1.5 or 2 or any other accelerator factor that will result in an appropriate depreciate rate. One of the commonly used accelerators is “2” which doubles the straight-line depreciation rate. This method is also called double declining balance method because it doubles the straight-line depreciation rate.

If there is some salvage value expected, the asset is not depreciated beyond that salvage value. If there is no salvage value, unlike the straight-line method, declining balance method does not completely depreciate the asset. The asset will be substantially depreciated but will not be fully depreciated over the useful life because of the mathematical structure of the formula i.e. depreciation is calculated as a percentage of current net book value, so it will not be able to completely depreciate the asset. Therefore, when the asset is substantially depreciated over its useful life, management of an entity can depart from the declining balance method and completely depreciate the asset, if the depreciation expense is immaterial in the context of overall financial statements.

Let’s take a look at the following example to clarify declining balance method of depreciation.

Example

On 1 July 20×1, XYZ Company purchased a refrigerator manufacturing plant costing $550,000 whose useful life is estimated to be 5 years. The plant’s salvage value or residual value is estimated to be $50,000. The company’s financial year is from January to December. Let’s see how depreciation expense is calculated using declining balance method.

Straight line depreciation rate can be calculated by taking the reciprocal of the asset’s useful life. In this case, 1/5 gives us the depreciation rate of 20% per annum. Based on the previous experience of the company, it is estimated that this rate should be doubled to better depict the usage pattern of the asset. So, 20% multiplied by 2 has resulted in the depreciation rate of 40%. Let’s calculate depreciation expense using depreciation rate of 40% per annum.

YearOpening NBVDepAcc depClosing NBV
20×1*550,000110,000110,000440,000
20×2440,000176,000286,000264,000
20×3264,000105,600391,600158,400
20×4158,40063,360454,96095,040
20×595,04038,016492,97657,024
20×657,0247,024500,00050,000
20×750,000500,00050,000

* In the first year, $550,000 represents the cost of plant which is purchased midway through the year. In this example, depreciation of first year is less than second year because depreciation expense of half year is charged in year 20×1, as the asset was available for use only for half year i.e. From 1 July 20×1 till 31 December 20×1.

It must be noted that in year 20×6, depreciation would have been $22,810 at the rate of 40%, however, as this would have taken the carrying amount below the salvage value of asset, therefore depreciation is restricted to $7,024.

Machine hours method of depreciation

For plants and machinery, machine hours method of depreciation can be used to calculate depreciation. In this method, useful life of an asset is determined in terms of total working hours capacity. The cost of the asset is depreciated based on hours utilized compared to total working hours capacity of the asset.

Formula

Depreciation under machine hours method can be calculated using the following formula:

Depreciation expense = Depreciable amount x (Hours utilized / Total working hours capacity)

Depreciable amount is calculated by subtracting salvage value from the cost of the asset.

Units of production method of depreciation

For plants and machinery, units of production method of depreciation can be used to calculate depreciation. In this method, useful life of an asset is determined in terms of total production capacity. The cost of the asset is depreciated based on units produced compared to total production capacity of the asset.

Formula

Depreciation under units of production method can be calculated using the following formula:

Depreciation expense = Depreciable amount x (Units produced / Total production capacity)

Depreciable amount is calculated by subtracting salvage value from the cost of the asset.