IAS 16 Property, Plant, and Equipment cover the accounting treatment for fixed assets. These assets include resources used by companies in the long term. Usually, companies acquire these assets to help support their operations.
This process requires substantial capital investments in various resources. For the company, the process results in a cost or expense. However, this cost differs from others in the income statement.
IAS 16 does not allow companies to write off an asset in its acquisition period. Similarly, the matching principle in accounting may dictate the process. This principle states that companies must match expenses to the revenues they help generate.
Since assets contribute to revenues across several periods, companies cannot charge them for a single period. However, IAS 16 presents a solution to this issue.
IAS 16 requires companies to use depreciation to expense out an asset. This process applies to almost every fixed asset with some exceptions, for example, land.
However, some people may wonder how to classify the cost. More particularly, they question if depreciation is a part of operating expenses. Before discussing that, it is crucial to understand what depreciation is.Cons
What is Depreciation?
Depreciation is a method to spread an asset’s cost over several periods. Usually, companies can choose between various approaches to the process. For example, they can use straight-line, declining balance, or other depreciation methods.
This process requires spreading the depreciable amount for the asset over its useful life. Alternatively, companies can use a percentage to depreciate their resources.
Depreciation turns an asset’s cost into expense over several periods. On the other hand, it also decreases its carrying value on the balance sheet. Depreciation is also crucial in matching expenses to revenues under the matching concept.
As stated above, assets contribute to income in several periods. Therefore, the depreciation process spreads the cost of that asset to the revenues it helps generate.
Depreciation only applies to tangible fixed assets. Companies can also spread the cost of intangible assets across various periods.
However, that process falls under amortization. Similarly, it does not apply to short-term or current assets. Companies usually expense those assets out in the same period as they help generate revenues. Nonetheless, depreciation is crucial to reducing an asset’s carrying value and spreading it.
Depreciation also represents how much of an asset’s value a company has used since its acquisition. This process falls under the requirements of IAS 16.
Usually, this process applies to every company that owns or controls fixed assets. Companies must use this process consistently for several asset classes. For some assets, such as land, depreciation may not apply.
What Kind of Assets Can Companies Depreciate?
Several assets fall under the depreciation process. Companies must depreciate all those assets consistently. However, they may not understand if they can apply this process to a specific asset.
Essentially, companies must use depreciation for all items classified as property, plant, or equipment. In other words, it applies to all resources that fall under the criteria set by IAS 16.
Essentially, companies must only depreciate fixed assets. These assets must meet several requirements to satisfy the criteria for depreciation.
Firstly, companies must only depreciate items that fall under the definition of an asset. This definition includes various parts. If those parts do not apply to the underlying resource, they will not fall under assets. Similarly, companies can’t depreciate them.
An asset includes a resource that companies own or control. It covers all items that companies hold on-premises to perform business activities.
However, it excludes resources such as those falling under operating leases. These are assets that companies don’t own or control.
Similarly, these resources must result in an inflow of economic benefits in the future. If these inflows are not expectable, the item won’t classify as an asset.
The above requirements come from the definition set for assets under the contextual framework. Some other criteria may also apply to these assets.
For example, it includes the underlying resource to have a reliable and measurable value. On top of that, it must be under use to fall under the depreciation process. Companies must also be able to determine their useful life. Similarly, that life must be longer than a year.
Usually, companies can depreciate the following assets.
- Building.
- Real estate excluding land.
- Office equipment and furniture.
- Machinery.
- Computers and electronics.
- Vehicles.
Is Depreciation an Expense?
The term depreciation covers two items in accounting. The first is the depreciation expense charged to the income statement. Essentially, this expense comes from the depreciation method used to depreciate an asset.
Companies use various methods to calculate this amount, as stated above. Once they do so, they report it in the income statement. In this case, depreciation is an expense.
The definition for expenses set by the contextual framework also covers depreciation. Essentially, this definition defines “Expenses” as outflows of economic benefits during a period.
Since depreciation satisfies the criteria this definition sets, it is an expense. Consequently, companies present it in the income statement as a profit reduction. Similarly, the accounting for depreciation also reflects this classification.
On the other hand, depreciation also refers to the accumulated amount for different assets. Companies that expense an asset out will include this amount in a contra-asset account. This account is called accumulated depreciation.
Any amounts in this account decrease the carrying value of assets reported in the balance sheet. In this case, depreciation is not an expense.
However, the above case only applies to accumulated depreciation. The term depreciation on its own can cover the expense or the contra-asset account.
Accounting only includes the former definition. Hence, depreciation is an expense. The latter definition only applies when referring to accumulated depreciation. However, some people may still confuse between the two.
Is Depreciation Part of Operating Expenses?
As mentioned above, depreciation applies to almost every asset a company owns or controls. Similarly, it may include various resources, as listed above.
These resources may be a part of different areas for operations. For example, some relate to the production activities performed by a company. In these cases, the assets contribute directly to the core activities of the underlying company.
In contrast, depreciation also applies to other assets that do not contribute to core activities. These may include items such as office equipment or building. In this case, the underlying resource is still a part of the business and operations.
However, it is not a direct cost to the product or services produced by the company. When reporting depreciation, companies must differentiate between those assets.
Depreciation is a part of the cost of sales and operating expenses. However, it will fall under the former. For instance, depreciation on machinery and factory will fall under the cost of sales.
The depreciation will appear under operating expenses if the resource relates to operating activities. Separating those assets is crucial for companies to report an accurate amount.
Sometimes, companies may use the same asset for various purposes. In these cases, it is challenging to determine whether depreciation is an operating expense or not.
Accounting standards allow companies to estimate the charge for each category based on percentage. Consequently, they can divide the depreciation for those assets based on estimation.
Conclusion
Depreciation involves spreading an asset’s cost over the periods it helps generate revenues. This process is in line with the requirements set by IAS 16.
On top of that, it also conforms to the matching principle in accounting. Depreciation can be an operating expense or classified as the cost of sales. The difference depends on the underlying asset and its usage within operations.
