Depreciation and amortization methods are how an entity used to allocate or charge the expenses on fixed assets that the company use for their operational purpose into the financial statements, specifically, in the income statement, in systematic ways based on the method allowed by applicable accounting standards.
As we all know, almost all of the accounting standards, including IFRS, US GAPP, or Local GAPP that follow by the specific country, allow the company not to charge the expenses that they are purchasing in the income statement at the time of purchasing.
The two main important accounting standards that use worldwide are US GAAP and IFRS.
For example, if your accounting record follows IFRS, depreciation and amortization of tangible fixed assets and intangible fixed assets have been discussed in IAS16 Property, Plant and Equipment, and IAS38 Intangible Assets.
You need to use these two standards to apply for depreciation and amortization.
This article will discuss the applicable depreciation and amortization methods that allow allocating expenses related to tangible and intangible assets into the company’s financial statements under IFRS.
These depreciation methods could apply only for financial statements that use IFRS standards and might not be applicable for preparing financial statements that use US GAAP or other local GAAP.
If your company’s financial statements are not prepared under IFRS, it is recommended to check with your local GAAP.
Check if your country adopts IFRS? Click here.
Depreciation Methods of Fixed Assets:
Based on IAS16, the depreciation method used shall reflect the pattern in which the asset’s future economic benefits are expected to be consumed by the entity.
Different assets are consumed differently by the entity, and the way those assets contribute to the increase in the entity’s economy is also different.
Therefore, the company should consider selecting the method that truly reflects how the company is using it. As per IAS 16 mention, three depreciation methods include the straight-line method, the diminishing balance method, and the units of production method.
However, it also mentions various methods that could be used as long as it respects the pattern of assets.
The following is the list of depreciation methods that normally use and allow by standard IAS 16, IFRS.
1) Straight-line method:
The straight-line depreciation method is one of the most popular methods that charges the same amount over the useful life of assets. This method is quite easy to compare to the other method.
An example of the straight-line depreciation method would be that the company has a car value of USD10,000. It is the company policy to depreciation its assets based on straight-line depreciation.
For such assets, the depreciation rate assumes 20%. Therefore, the depreciation per year would be USD2,000 equally.
See the table below for detail:
|Year ending||Rate||Cost/carrying value||Depreciation|
Disclaimer: Using the straight-line method to depreciate the car might not be appropriate as the car value normally reduce its value in the first year. We use car as the example for easily communicate only.
2) Diminishing balance method:
Using the diminishing balance method, the depreciation amount or expenses in the first year will be high and decrease in the subsequent year.
The main reason is that the expense results from multiplying the rate to the book value in the first year and carrying amount in the following year. You will understand this better in the example below.
This concept is used to assume that the assets are more productive in the first years and subsequently less productive as the asset gets older. In the example below, we use a basic or depreciation rate based on the net book value of assets.
Therefore, the depreciation expenses in the first year are the same, but they will be based on the next book value of USD8,000 (USD10,000 – USD2,000) in the second year.
The depreciation in the second year is 1,600 (8,000 * 0.2). Based on this figure, you could see the depreciation in the second year is less than the first year. See the table below for the detail:
|Year ending||Cost||Carrying value||Rate||Depreciation||Accumulated Depreciation|
3) Unit of production method:
The unit of production method is the type of depreciation method allows by IFRS.
In this method, the assets will be depreciated based on, for example, the unit of products that assets contribute for the period compared to total products that are expected to be contributed or actual production output.
This method is a bit complicated as you require to estimate the production units that assets could run for in the whole useful lift.
But, it is also the most accurate method for calculating depreciation. For example, the machine costs $10,000, and the machine could run 100,000 Hours.
The table below shows the actual hours that the machine runs each year.
Base on the data above, here are the depreciation expenses per year using the unit of production method.
4) Declining or reducing balance method
For example, the car could run for 10,000 kilometers per its useful lift, and this year it already runs for 2,500 kilometers. Therefore, the depreciation for first year would be USD2,500 [(2,500*10,000)10,000].
Declining and reduce the balance method is the same thing. In this method, depreciation will be charged on the rate provided to assets at the net book value after eliminating residual value.
This type of depreciation method is a bit difficult compared to the straight line, and it applies to certain types of fixed assets where the value of used or the benefit from the use is high at first and then subsequently reduces from time to time.
This kind of depreciation keeps charging forever if you don’t determine the residual value and number of years to be used.
5) Double declining balance method
Double declining is similar to declining above, but the rate is a bit different. For a decline, the rate is provided to fixed assets based on their class.
However, for double declining, the depreciation rate is based on the rate in a straight line. For example, the computers will be depreciated at 25% using a straight-line method for four years.
And if we change to use double declining, the depreciation rate will be double from 25% to 50% in the first year to its net book value.
According to IAS16, FIRS, amortization methods apply the same concept to depreciation methods.
How often should you assess the useful life of the assets?
The quality and performance of assets could be changed from time to time, and the value of those assets contributing to the company’s value could be changed and different from time to time. Initial assessment of the asset performance and its useful life could be different from reality.
It could be longer or shorter, depending on the quality of assets or on how the company uses them. To ensure that the value of assets at the end of the fair value, you should evaluate the useful life of your company’s assets at least once per year.