- slide 1 of 5
The Purpose of Depreciation
Depreciation is intended to match the rate of consumption of the economic benefit of an asset over its useful life; resulting in a charge to the profit and loss account in each accounting period, representing the consumption of that asset. in earning the sales revenue in that accounting period. Generally, the depreciation figure is arrived at by dividing the cost or market value of the asset, by its estimated useful economic life. On the balance sheet, depreciation is credited against the cost of the asset. The balance sheet would normally show the original cost or valuation of the asset, the accumulated depreciation on that asset up to the balance sheet date, and the resulting net book value of the asset.
The depreciation charge therefore represents the wear and tear that the asset has sustained during its useful life in earning income for the business, and is therefore properly included as an expense in the profit and loss account, even though it is a non-cash item. The depreciation charge may also represent technical obsolescence of the asset, resulting from the availability of more advanced equipment that could now do the same task more efficiently. The depreciation charge might also reflect commercial obsolescence of the asset, resulting from changes in trends or tastes that have reduced demand for the product that the asset is used in manufacturing. Any legal restrictions on the use of the asset could also be taken into account in arriving at the depreciation charge.
- slide 2 of 5
The age-life method of depreciation is used by residential appraisers, and involves assessing the depreciation of an asset, based on the effective age of the asset. The effective age differs from the actual age of the asset, and is estimated on the basis of the amount of wear and tear that the asset has undergone. Excessive wear and tear in comparison to the actual age, will mean that the asset is assigned an effective age that is greater than its actual age.
For example, take an asset that was constructed five years ago, but owing to excessive wear and tear, the asset is not in good condition. It is therefore considered to have an effective age of 15 years. If the total economic life of the asset is considered to be 30 years, the accumulated depreciation of the asset will then be computed using 50% of the cost or market value of the asset.
In the case of a building that is four years old with an estimated useful life of 50 years, this may have sustained considerable wear and tear for various reasons during its first four years of life, with the result that it is assigned an effective age of 10 years. The accumulated depreciation of the building could therefore be computed at 20% of the original cost.
Where this type of assessment is performed frequently, depreciation of the asset can be allocated to accounting periods based on the amount of wear and tear that the asset has actually sustained, rather than by a more mechanical formula based on a percentage of cost or net book value. The age-life method of depreciation may therefore have some use in determining the depreciation charge for accounting purposes.
- slide 3 of 5
Disadvantages of Age-Life Depreciation
The assignment of an effective age to an asset, is a subjective judgment based on the past experience of wear and tear in similar assets. Given that the estimate of the total economic life of the asset is also a matter of subjective judgment, there is clearly a very significant element of judgment in calculations, using the age life method of depreciation that may be considered a source of potential discrepancies in the assessment of the depreciation charge.
However this introduction of subjective judgment into the equation could also be considered to be an advantage over methods such as straight line depreciation and the declining balance method which are applied mechanically in each accounting period and do not involve any assessment of the wear and tear of the asset (except where a separate charge might be made for impairment). The straight line depreciation method assumes that depreciation occurs at the same rate over the life of the asset, an assumption that may not be in line with reality. The declining balance method assumes greater depreciation in the earlier years of the life of an asset, but this assumption may be equally far from the reality of a particular situation. The straight life and declining balance methods also involve an element of judgment in determining the useful economic life of the asset being depreciated.
However it might also be considered that the introduction of significant subjective judgment into determining the amount of depreciation charged might give some room for creative accounting, setting a depreciation charge for the year that suits the aims of the company preparing the accounts. This could be overcome by ensuring that the relevant judgments are made by an independent professional. The depreciation charge in the accounts would also be reviewed by the auditors.
- slide 4 of 5
Age-Life Depreciation and Accounting Standards
The international accounting standard (IAS 16) dealing with property, plant and equipment states that the method of depreciation used in calculating the depreciation charge should take into account the pattern in which the economic benefits that the business receives from the asset are consumed by the business over the useful life of the asset. The accounting standard requires a business to regularly review the residual value that will remain at the end of the asset’s life and the length of the useful economic life of the asset.
Some aspects of the age life method of depreciation would be helpful to companies in assessing their depreciation charge for the year, as a genuine attempt is made to look at the amount of wear and tear of the asset. However the subjective element involved in calculating age-life depreciation makes it rather less suitable for use in accounting. For this reason the more traditional methods such as straight line depreciation and the declining balance method which are better understood by users of accounts are likely to retain their popularity.