How to determine the right depreciation method for fixed assets?

What is a fixed asset?

An asset is any tangible resource controlled by an entity, as a result of past events (for example purchasing), from which an inflow of future economic benefits is expected.

However, a fixed asset is an asset held by the entity for a long-term use in order to generate income.

Fixed assets or Non-current assets are also referred to as property, plant and equipment.

Such assets are not easily convertible into cash like inventory items and are not purchased with the intention of resale. Following items are some examples of fixed assets:

  • Machinery
  • Building
  • Motor Vehicles
  • Computer Equipment
  • Fixture and fittings
  • Land
  • Office equipment

How to report fixed assets in the financial statements:

According to the matching principle of accounting, only those expenses should be reported in the income statement, incurred in order to generate revenue for that year only. In simpler words, the expenses should match the revenue it has generated.

Secondly, when we talk about property, plant or equipment – these assets are huge investments.

It would be unfair to charge the entire amount in one accounting period. The company would incur a huge loss every time it invests in a fixed asset.

To be able to deal with these concepts, IAS 16 was introduced for property, plant and equipment.

The cost of the fixed asset is spreaded over its useful life so that the huge investment cost is allocated fairly to each accounting period it has been used to generate income.

This process is called depreciation of fixed assets. Depreciation is the reduction in the value of a fixed asset due to obsolescence, wear and tear or usage.

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The depreciation amount is treated as an operating expense in the income statement whereas the asset is reported at its Net Book Value (Cost – Accumulated Depreciation) in the balance sheet. There are precisely four methods of depreciating an asset named as follows:

  • Reducing balance
  • Straight-line
  • Units of production
  • Sum of years’ digits

The depreciation policy of each entity is an accounting policy which should stay consistent throughout all accounting periods as per the principle of consistency of accounting unless there is a significant change in the pattern of future economic benefits from the asset. This concludes that we could only adopt one method of depreciation.

Which method of deprecation should we adopt?

The method of depreciation depends on the type of asset. You should choose depreciation methods depending on how you choose to use the asset.

If your asset is a machinery or plant that works best during the initial years of its useful life and loses its capacity over time, then you should use the reducing balance method.

In this method, the depreciation is charged more in the early years of the asset and the depreciation amount reduces in each accounting period over time.

If you expect to use the asset equally every year, for example a building that is being used as a head office for your company, then the straight-line method should be used. The cost of the asset is spread evenly throughout its useful life through this method.

Units-of-production method depreciates the asset on the basis of a measurable quantity, for example the units produced or machine hours used during the accounting period.

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Hence if your asset generates a quantifiable commodity, you can allocate the cost of asset over its usage.

The last method, sum of year’s digits, is used when the asset is assumed to have higher capacity in its early life. It is similar to the reducing balance method and charges a higher depreciation in its early life.