Depreciation and amortization methods are the way that entity used to allocate the expenses on fixed assets into the financial statements in systematic ways based on the method that allowed by applicable accounting standards.
The two main importance accounting standards that use worldwide are US GAAP and IFRS.
For example, if your accounting record is followed IFRS, Depreciation, and amortization of tangible fixed assets and intangible fixed assets have been talked very detail in IAS 16 Property, Plant and Equipment, and IAS 38 Intangible Assets.
You need to use these two standards to apply for depreciation and amortization.
In this article, we will discuss the applicable depreciation and amortization methods that allow being used in allocating expenses related to tangible and intangible assets into the company’s financial statements.
These depreciation methods could apply only for financial statements that use IFRS standard and they might not applicable to be used for preparing financial statements that use US GAAP or other local GAAP.
Depreciation Methods of Fixed Assets:
Based on IAS 16, the depreciation method used shall reflect the pattern in which the asset’s future economic benefits are expected to be consumed by the entity.
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 that there are a variety of methods that could be used as long as it respects the pattern of assets.
The following are the list of depreciation methods that normally use and also allow by standard IAS 16, IFRS.
The straight-line depreciation method is one of the most popular methods that charges the same amount of over the useful life of assets. This method is quite easy to compare to the other method.
The example of Straight-line depreciation method would be, let say the company has car value 10,000, and 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 USD 2,000 equally.
Diminishing balance method:
Using the diminishing balance method, the depreciation amount for the first year will be high and decrease in the subsequent year.
The concept is the assets are more productive in the first years and subsequently less productive. By using the same example, but the basic of depreciation is based on the net book value of assets.
Therefore, the depreciation expenses in the first year us the same but the second year it will be based on the next book value USD8,000(USD 10,000 – USD 2,000).
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.
Unit of production method:
The unit of production method is the types of depreciation methods that allow by IFRS.
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 expected to be contributed.
This method is a bit complicated as you require to estimate the production units that assets could run for in the whole useful lift.
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 USD 2,500 [(2,500*10,000)10,000].
Declining and reduce the balance method is the same thing. 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 is applicable to certain types of fixed assets where the value of used or the benefit from the use is high at the 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.
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 its class.
However, for double declining, the rate of depreciation 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 IAS 16, FIRS, amortization methods apply the same concept to depreciation methods.