Recognition of Fixed Asset:
According to IAS 16 fixed assets should be carried at cost less accumulated depreciation and impairment.
Any impairment or depreciation expense against a fixed asset should be charged to the income statement.
Depreciation is the process of allocating the depreciable amount of the asset (cost less residual value) to its useful life on a systematic basis.
Hence, in each accounting period the new carrying amount (cost less accumulated depreciation) should be reported on the balance sheet.
Method of depreciation:
There are four known methods of depreciating a Non-current asset:
- Straight-line: charges depreciation equally over the useful life
- Double declining: charges a higher depreciation expense in the early years and the depreciation expense reduces every year.
- Sum of year’s digits: charges higher depreciation expense in the early years and the amount reduces every year.
- Units of production: charges depreciation based on usage meaning, the more the production the higher the depreciation expense and vice versa.
Every entity should opt for one depreciation method influenced by the revenue the asset generates.
This must stay consistent throughout its useful life unless there is a significant change in the pattern of consumption of benefits generated from the asset.
Straight-line method of depreciation:
In this article, we are going to talk about the straight-line method of depreciation specifically. This method is used when the asset doesn’t have a particular pattern of generating income, for example an office desk.
The depreciable amount of an asset is allocated equally over its useful life through this method. In other words, the annual depreciation expense would be the same for every accounting period.
This is literally the easiest method of depreciation and is mostly used resulting in fewer calculation errors.
The formula to calculate annual depreciation through the straight-line method is:
= (Costs – Salvages Value) / Useful Life of Assets
Where, cost of the asset is the initial amount you paid to purchase the asset and bring it to its current condition.
Useful life of the asset is the period of time you expect to use this asset and generate economic benefits from it.
Salvage value or scrap value or residual value is the amount you expect to receive at disposal of the asset at the end of its useful life.
You can calculate the rate of depreciation by dividing 1 with the useful life of the asset and multiply the rate with the cost of asset to calculate the cost of depreciation i.e.
= Cost of Assets / Useful Life of Assets
Willy Corporate has a manufacturing business of toys and in order to increase its capacity, purchased a machine for the business costing $110,000.
Willy expects to manufacture toys with this machine for the next 10 years and is hoping that the machine would sell for $1000 at the time of disposal.
Calculate the annual depreciation expense if Willy has a policy of charging depreciation using the straight line method.
Cost of asset = $110,000
Salvage value = $10,000
Depreciable amount of asset (Cost – SV) = $110,000 – $10,000 = $100,000.
Annual depreciation = $100,000/ 10 = $10,000.
Rate of depreciation = 1/10 x 100 = 10%
Depreciable amount of asset = $110,000 – $10,000 = $100,000
Depreciation expense = $100,000 x 10% = $10,000. Willy Corporate would charge an expense of $10,000 every year for 10 years in his profit and loss account.
This shows that the cost of asset is being allocated evenly throughout its life and at the time of disposal it would have a value of $10,000 i.e. the scrap value, as expected.