Depreciation is the method through which companies account for the loss in the value of their long-term assets (like machinery, buildings, vehicles, etc.) over time. It's important because it matches the cost of using the asset with the income the asset helps to generate, making the financial statements more accurate.
IAS 16 allows companies to use different methods to calculate
depreciation. The goal is to spread the cost of an asset over its useful life
in a way that reflects how the asset is used. In this post, we’ll discuss the
main depreciation methods used by different companies.
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Straight-Line Method
The straight-line method is the simplest and most
common way to calculate depreciation. Under this method, the same amount of
depreciation is recorded every year over the asset's useful life.
How It Works:
You take the total cost of the asset, subtract its residual
value (if any), and divide that by the number of years the company expects
to use the asset (its useful life).
Residual Value (Salvage Value) is the estimated amount the
company expects to receive when the asset is sold or discarded at the end of
its useful life.
Formula:
Example:
Let’s say a company buys a machine for ₦10,000. It expects to use
the machine for 5 years, and the machine will have no residual value at the end
of its life.
Annual depreciation = (₦10,000 - ₦0) ÷ 5 = ₦2,000
So, the company will record ₦2,000 as depreciation expense in its
income statement every year for 5 years.
When to Use:
The straight-line method is best when the asset is used evenly over time, like office furniture or buildings.
Diminishing Balance (or Declining Balance) Method
The diminishing balance method assumes that the asset
loses more value in the earlier years of its life. Depreciation is calculated
based on a percentage of the asset's carrying amount (the value of
the asset after previous depreciation has been subtracted).
This method results in higher depreciation expenses in the
earlier years and lower depreciation expenses later on. It’s also known as
the reducing balance method or declining balance method.
How It Works:
The depreciation is calculated by multiplying the carrying amount
of the asset by a fixed percentage (called the depreciation rate). The
carrying amount is reduced each year as depreciation is charged.
Formula:
Depreciation Expense = Net book
value × Depreciation Rate
Net book value (NBV) is the asset’s value at the beginning of the
period (after subtracting previous depreciation). It is also the carrying amount of
the asset at beginning of year.
Example:
If a company buys equipment for ₦10,000 and applies a
depreciation rate of 20%, here’s how the depreciation will be calculated:
Year 1 depreciation = ₦10,000 × 20% = ₦2,000
Carrying amount at the end of Year 1 = ₦10,000 - ₦2,000 = ₦8,000
Year 2 depreciation = ₦8,000 × 20% = ₦1,600
Carrying amount at the end of Year 2 = ₦8,000 - ₦1,600 = ₦6,400
As you can see, the depreciation expense decreases each year.
When to Use:
The diminishing balance method is useful for assets that lose value faster in their early years, like technology or vehicles, where more benefits are derived earlier in the asset's life.
Units of Production Method
The units of production method ties depreciation
directly to how much the asset is used. Depreciation is based on how many units
the asset produces or how many hours it operates, instead of being spread evenly
across time.
How It Works:
First, estimate the total number of units the asset is expected
to produce over its life or the total number of hours it will be used.
Then, depreciation is calculated for each period based on the
actual units produced or hours used.
Formula:
Depreciation Expense = Depreciation
per unit × Units produced in the period
Example:
A company buys a machine for ₦20,000. It expects the machine to
produce 100,000 units over its lifetime, with no residual value.
Depreciation per unit = (₦20,000 - ₦0) ÷ 100,000 = ₦0.20 per unit
If the machine produces 15,000 units in Year 1, depreciation for
that year would be:
₦0.20 × 15,000 = ₦3,000
And so on for subsequent years.
When to Use:
The units of production method is ideal for machinery or equipment where wear and tear depends on how much it’s used, such as a printing press or an airplane engine.