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Length of the Depreciation Period
The length of the depreciation period of an asset should be decided on the basis of the purpose of the depreciation charge in the accounts. The objective of the depreciation charge is to match the use of the economic benefit of the asset against the income that has been earned through the use of that asset, so that costs and revenue are matched appropriately. The depreciation period should, therefore, reflect as closely as possible the useful economic life of the asset. The amount of depreciation charged in each accounting period should correspond to the wear and tear sustained by that asset in earning income for the enterprise in that accounting period.
Therefore, when an enterprise considers longer depreciation or shorter depreciation, which is better depends on the facts of the situation and the nature of the asset. The enterprise must decide which depreciation period and which depreciation method is better for matching the depreciation charge to the wear and tear of the asset in each accounting period. This always depends on the facts of the situation; the enterprise should not just rely on a general formula.
- slide 2 of 7
Useful Economic Life of an Asset
The length of the depreciation period for an asset is closely linked to the useful economic life of that asset. The enterprise must therefore give careful consideration to the length of the useful economic life. This will be linked to the amount of physical wear and tear that will be sustained by the asset, and the enterprise will have to take into account the extent to which it is to be used in the business and the pattern of use. In estimating the economic life of the asset, the enterprise can take into account the level of maintenance and repair that will be received by the asset and the average useful life of that type of asset generally.
Depending on the type of industry in which it operates, the enterprise may need to take into account the length of time likely to elapse before the asset is obsolete and needs to be replaced by a more advanced model. Also, depending on the goods or services that the asset will be helping to produce, the enterprise may need to consider the length of time that will pass before the product that the asset is designed to make goes out of fashion, or before demand goes down because the needs and tastes of customers have changed.
For a specialized asset such as a machine that is devoted to producing one particular line of goods, the above considerations regarding obsolescence should be taken into account, and the depreciation period should be shortened if necessary. The danger is that if the asset, though still in good operating condition, falls out of use because demand goes down, it will continue to be depreciated while it is no longer of use in earning profits. In a high-tech industry where new models appear every year or two, depreciation periods of machines and equipment are always likely to be low because of these considerations.
For an asset such as a building that can be easily switched from one use to another, these considerations of obsolescence are not so relevant, though for certain specialized types of building they must be taken into account.
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The international accounting standard IAS16 states that depreciation should be allocated on a systematic basis over the useful life of the asset, and that the useful life and residual value of the asset should be reviewed at each financial year end, at least. Depreciation of the asset should, if necessary, be adjusted for changes in these figures. Under the international accounting standard, the depreciation method used for the asset should reflect the pattern in which the asset’s economic benefits are used by the enterprise. This should also be reviewed annually and adjustments made where the pattern of consumption of benefit from the asset changes. The standard also provides for testing for impairment of an asset, and for recognition of that impairment in the accounts if necessary.
In deciding between longer depreciation or shorter depreciation, which is better depends on which depreciation period enables the enterprise to conform to the accounting standard used. In order to implement the international accounting standard, it is necessary to arrive at a reasonable estimate of the economic useful life of the asset.
- slide 4 of 7
The choice of a depreciation method must take into account the length of the useful economic life, the residual value of the asset at the end of its life, and the pattern of consumption of the benefits from the asset over its useful life. For some assets such as buildings, a straight line method of depreciation is likely to be suitable, because the benefit to the business from using the building is likely to be similar in each accounting period over its useful life. The allocation of the same proportion of its cost or market value each year to the depreciation charge is reasonable.
For certain other assets such as vehicles, the economic benefit from the asset may be greater in the earlier years when it is functioning efficiently. Even allowing for adequate maintenance, the benefit from some vehicles may decline as they reach the end of their useful economic life, owing to unreliability and inadequate capacity to do a task that newer models might perform more efficiently. For such assets, a declining balance method of depreciation over the useful life might be a closer approximation to the use of the economic benefits of the asset by the enterprise.
Whatever method of depreciation is used, the useful economic life and residual value of the asset, as well as the appropriateness of the depreciation method used, should be reviewed at the end of each accounting period.
- slide 5 of 7
The tax treatment of fixed assets differs depending on the jurisdiction in which the enterprise is operating. Some jurisdictions may give a tax deduction for depreciation but lay down strict guidelines for the calculation of that depreciation for each class of asset. Other jurisdictions do not give a deduction for the depreciation charge in the accounts (which must therefore be added back to the net profit in computing the taxable profit) but instead give standard allowances based on the original cost of the asset and the written down value for tax purposes.
An enterprise that is compiling accounts in accordance with accounting standards should not be influenced by any tax considerations when determining the useful economic life and depreciation method of a particular asset. The accounts are used by many different stakeholders such as investors, employees and creditors. It is, therefore, necessary to compile the accounts according to best practice as represented by accounting standards to give the best possible guidance for these stakeholders. This involves determining the depreciation charge based on the consumption of the economic benefit of the asset in the particular accounting period, and the depreciation should be computed on that basis.
- slide 6 of 7
Determining the Depreciation Period
How does one decide between longer depreciation or shorter depreciation--which is better? The answer must be based on the facts of the situation rather than on any calculation relating to the effect on profits. The question of which is better depends on the nature of the asset and its use by the enterprise. This is a decision that should be made with the objective of ensuring that the accounts of the enterprise are prepared according to accounting standards, national laws and best practice.