What is depreciation? Methods and worked examples

What depreciation is

Depreciation is the systematic allocation of the cost of a tangible long-term asset, less its expected residual value, over the years in which the asset is used. It is not a valuation and it does not use cash. It matters because it matches the cost of machinery, vehicles and equipment to the revenue they help earn, so profit in each year is stated fairly.

Under IFRS the rules sit in IAS 16 Property, Plant and Equipment. IAS 16 para 50 requires the depreciable amount of an asset to be allocated on a systematic basis over its useful life. The same idea applied to intangible assets such as software licences or customer lists is called amortisation (IAS 38), and a lessee depreciates its right-of-use assets under IFRS 16. Land is normally not depreciated because it is treated as having an unlimited useful life.

Every depreciation charge is the same journal: Dr Depreciation expense / Cr Accumulated depreciation. Accumulated depreciation is a contra-asset account, so the balance sheet shows cost, less accumulated depreciation, equals net book value (also called carrying amount).

The four inputs you need before you calculate anything

Every depreciation method uses the same inputs. Get them right first, because a perfect formula applied to a wrong useful life still produces the wrong profit.

• Cost: purchase price plus import duties and non-recoverable taxes, delivery, installation and the costs of bringing the asset to working condition, less trade discounts. Recoverable VAT or GST is not part of cost.
• Residual value: the amount the entity would obtain today from disposal if the asset were already of the age and condition expected at the end of its useful life, less disposal costs.
• Useful life: the period the entity expects to use the asset, which may be shorter than its physical life. It can be expressed in years or in units such as machine hours or kilometres.
• Depreciable amount: cost minus residual value. This is the total that will be charged over the useful life.
• Start date: depreciation begins when the asset is available for use, meaning in the location and condition needed to operate as intended (IAS 16 para 55), not when the invoice is paid.
• Pattern of use: the method must reflect the pattern in which the asset's economic benefits are consumed (IAS 16 para 60).

Straight-line depreciation with a worked schedule

Straight-line depreciation charges the same amount every year. The formula is (cost minus residual value) divided by useful life. It suits assets that deliver roughly even benefits over time, such as office fit-outs, furniture and most buildings, and it is the most common choice in practice.

Worked example used throughout this guide: a production machine costs EUR 50,000, has an estimated residual value of EUR 5,000 and a useful life of five years. The depreciable amount is EUR 45,000, so the annual charge is EUR 45,000 divided by 5, which is EUR 9,000. Expressed as a rate, that is 18 percent of cost per year (9,000 divided by 50,000).

• Year 1: charge 9,000, accumulated 9,000, net book value 41,000
• Year 2: charge 9,000, accumulated 18,000, net book value 32,000
• Year 3: charge 9,000, accumulated 27,000, net book value 23,000
• Year 4: charge 9,000, accumulated 36,000, net book value 14,000
• Year 5: charge 9,000, accumulated 45,000, net book value 5,000, equal to the residual value

Reducing balance (declining balance) depreciation

The reducing balance method applies a fixed percentage to the opening net book value each year, so the charge is highest in year one and falls every year. It suits assets that lose most of their usefulness early, such as vehicles, computers and technology that becomes obsolete. A common rate is double the straight-line rate, known as double-declining balance.

For the EUR 50,000 machine, the straight-line rate on a five-year life is 20 percent of the depreciable base, so the double-declining rate is 40 percent. Residual value is ignored when applying the rate but respected as a floor: in the final year the charge is whatever brings net book value down to the EUR 5,000 residual value. The five charges add up to 45,000, exactly the same total as straight-line; only the timing differs.

• Year 1: 40 percent of 50,000 = 20,000, net book value 30,000
• Year 2: 40 percent of 30,000 = 12,000, net book value 18,000
• Year 3: 40 percent of 18,000 = 7,200, net book value 10,800
• Year 4: 40 percent of 10,800 = 4,320, net book value 6,480
• Year 5: balancing charge 1,480, net book value 5,000
• Total charged over five years: 20,000 + 12,000 + 7,200 + 4,320 + 1,480 = 45,000

Sum-of-the-years' digits and units of production

Sum-of-the-years' digits (SYD) is another accelerated method. Add the digits of the useful life (for five years, 5 + 4 + 3 + 2 + 1 = 15) and charge the depreciable amount in the fractions 5/15, 4/15, 3/15, 2/15 and 1/15. For the machine, the depreciable amount of EUR 45,000 gives charges of 15,000, 12,000, 9,000, 6,000 and 3,000, which total 45,000 and leave net book values of 35,000, 23,000, 14,000, 8,000 and finally 5,000.

Units of production ties the charge to actual use rather than time. Divide the depreciable amount by total expected output, then multiply by output in the period. If the machine is expected to run 90,000 hours over its life, the rate is EUR 45,000 divided by 90,000, which is EUR 0.50 per hour. A year with 24,000 hours costs EUR 12,000; a quiet year with 18,000 hours costs EUR 9,000. It suits vehicles measured in kilometres, printing presses, mining equipment and anything whose wear depends on use.

One method is off limits under IFRS for property, plant and equipment: depreciation based on revenue generated by the asset is not appropriate (IAS 16 para 62A), because revenue reflects prices and sales volumes as well as the consumption of the asset.

Part-year depreciation and the first year

Assets are rarely bought on the first day of the financial year. The most accurate approach is time-apportionment by month or day from the date the asset is available for use. If the machine becomes available for use on 1 April and the year ends on 31 December, straight-line depreciation for the first year is EUR 9,000 multiplied by 9/12, which is EUR 6,750. The final partial year then picks up the remaining three months.

Some entities use a simplifying convention, such as a full year's charge in the year of acquisition and none in the year of disposal, or a half-year charge in both. A convention is acceptable when the result is not materially different from time-apportionment and it is applied consistently. Write the convention into the accounting policy so every asset is treated the same way.

Depreciation does not stop when an asset is idle or temporarily out of use, unless it is fully depreciated or classified as held for sale. Under a usage-based method, however, the charge can be zero in a period with no production.

Changing useful life, residual value or method (IAS 8)

IAS 16 para 51 requires the residual value and useful life to be reviewed at least at each financial year end, and para 61 requires the same review of the method. A revision is a change in accounting estimate under IAS 8. It is applied prospectively: past years are not restated, and the remaining net book value is spread over the revised remaining life.

Worked example: after two years of straight-line depreciation, the machine's net book value is EUR 32,000. At the start of year 3 engineers conclude it will last four more years rather than three, and the residual value is revised down to EUR 2,000. The new annual charge is (32,000 minus 2,000) divided by 4, which is EUR 7,500 for each of years 3 to 6. The effect is disclosed if material, but years 1 and 2 are left as reported.

Contrast this with an error. If the machine was never depreciated in year 1 because it was left off the register, that is a prior-period error under IAS 8, corrected retrospectively rather than absorbed into future charges. See our guide on finding and correcting accounting errors.

Disposals, impairment and components

When an asset is sold, remove both its cost and its accumulated depreciation, and recognise the difference between proceeds and net book value as a gain or loss in profit or loss. Suppose the machine is sold at the end of year 3 for EUR 25,000. Net book value is EUR 23,000 (cost 50,000 less accumulated depreciation 27,000), so there is a gain of EUR 2,000. The entry is Dr Bank 25,000 / Dr Accumulated depreciation 27,000 / Cr Machinery at cost 50,000 / Cr Gain on disposal 2,000. Debits and credits both total 52,000.

A large gain or loss on disposal is a signal that the depreciation estimates were wrong, which is useful feedback for the next review of useful lives.

Depreciation is not a test of value. If there is an indication that an asset's recoverable amount has fallen below its carrying amount, IAS 36 requires an impairment test and a write-down; depreciation then continues on the reduced amount. IAS 16 para 43 also requires each part of an asset with a cost that is significant in relation to the total to be depreciated separately, so an aircraft's engines, or a building's roof and lifts, may carry different useful lives from the main structure.

Book depreciation versus tax depreciation

The depreciation in the financial statements is an accounting estimate. Tax authorities usually ignore it and grant their own deductions on prescribed rates: capital cost allowance classes in Canada, capital allowances in the United Kingdom and Ireland, and official depreciation tables or fixed rates in many EU countries. The two figures differ in almost every year of an asset's life, even though both total the same cost over time.

The difference creates a temporary difference under IAS 12 Income Taxes. Illustration only, with assumed rates: if tax rules allowed a 25 percent writing-down allowance on the machine in year 1, the deduction would be EUR 12,500 against book depreciation of EUR 9,000. The tax base of the asset is then EUR 3,500 lower than its carrying amount, and at an assumed 25 percent tax rate the business recognises a deferred tax liability of EUR 875. The liability reverses as book depreciation catches up.

Keep a separate tax register with its own pools or classes. Using tax rates for the books because they are convenient misstates profit and asset values whenever the tax life differs from the real useful life.

Common depreciation mistakes to avoid

Most depreciation errors come from the fixed asset register rather than the arithmetic. Check for each of them whenever the register is reviewed.

• Starting depreciation on the invoice date instead of the available-for-use date, or not starting it at all for assets under construction that have been brought into use.
• Depreciating land, or failing to split a property purchase between land and building.
• Never reviewing useful lives, so the register fills with fully depreciated assets still in daily use, which signals lives were too short.
• Continuing to depreciate assets that were sold or scrapped because the disposal never reached the register.
• Capitalising repairs and maintenance that should be expenses, or expensing a major overhaul that meets the IAS 16 recognition criteria.
• Including recoverable VAT or GST in cost.
• Leaving the fixed asset register unreconciled to the general ledger cost and accumulated depreciation accounts.

How Skyline Nexus ERP handles depreciation

In Skyline Nexus ERP fixed assets are held in the Asset Management module, whose Lifecycle menu covers Depreciation, Revaluation, Impairment, Disposal and CIP. The Depreciation screen offers the four methods explained in this guide: Straight Line, Declining Balance, Sum of Years Digits and Units of Production. Depreciation runs monthly on a schedule.

Posting to the general ledger is controlled by a switch: when Auto-post Depreciation Entries is turned on under Fiscal Authority, Settings, the monthly depreciation posts a journal, and Auto-post Asset Disposal Entries does the same for disposals, with gain and loss accounts. Both toggles are off until an administrator enables them, so check them before relying on the ledger. Revaluation and impairment post when the user posts them in Asset Management. Reconcile the asset register to the fixed asset and accumulated depreciation accounts in the trial balance each month.