Methods of depreciating assets
Accounting standards demands that fixed assets are written down and depreciated over their useful economic life. This article explores the concept of depreciation and gives guidance on how to account for it inthe financial records.
How to depreciate fixed assets
When a business buys a fixed asset the cost, which consists of the actual purchase price plus the cost of any accessories as well as the costs incurred in getting the asset to its location and condition for intended use, must be capitalised on the balance sheet. The cost of asset cannot be charged through the profit and loss in the period of purchase.
An asset doesn’t last forever and will gradually wear up so it is only fair the market value or net book value of the asset be shown on the balance sheet. In order to write down the asset as it wears up an accounting entry called depreciation is charged to the profit and loss account to reflect the “using up” of the asset.
Different assets will wear up in different ways. Some will last for many years, whereas some may only last for a few years. For example a large piece of specialist machinery is likely to last for many years whereas a computer will become obsolete and need replacing in a couple of years. The depreciation rate and method is designed to reflect how the asset is used up, therefore it wouldn’t be right to depreciate the large piece of machinery and the computer, detailed above, in the same way.
The time it takes an asset to wear out is called its useful economic life and this needs to be considered when deciding what depreciation method is most suitable as the asset should be written off over this period. So, if an asset is likely to be used in the business for ten years this method would mean a tenth of it would be used up each year. If this asset cost $100,000, the depreciation charge would be $10,000 per annum (i.e. $100,000 divided by 10). This example is on the assumption the asset will be scrapped at the end of the ten years. If the assets is going to be sold and the directors of the business thinks the asset can be sold for $10,000 the depreciation charge would be $9,000 per annum (being $100,000 less $90,000 divided by 10).
The above method is simplistic and ideal for those assets where the useful economic life can be ascertained, but what about smaller assets? Small assets must also be capitalised at cost and then written off over a period of time so depreciation must be charged. When dealing with smaller assets these are pooled in categories, such as tools, equipment, plant and machinery or whatever else you care to call them and the depreciation is charged on the pool as a total.
The depreciation method can be straight line, which is where the depreciation charge is the same each year, or on a reducing balance, which is where the depreciation is charged as a percentage of the carrying value of the pool.
In practice, there are common rates and methods used and these are generally accepted. These common rates and methods include 25% straight line, 25% reducing balance, 15% reducing balance, 10% straight line, 10% reducing balance and 2% straight line, however the depreciation method and rate is entirely up to the directors of the business, therefore depreciation methods are always highly subjective. Whilst the depreciation method is little more than an accounting estimate there should be some rationale behind the charge, which should be defensible if challenged.
As depreciation methods and rates are so subjective it is important that the authorised and agreed rate and method used is clearly disclosed in the accounting policies section of the business’ financial statements.