Determining the Amount of Depreciation
Introduction
The
depreciation formula can be expressed as follows:
Depreciation expense = (Cost – Estimated residual
value)
Estimated useful life
The top left-hand corner of the formula is known as the
“depreciable amount”. According to paragraph 50 of AASB 116, the
depreciable amount of an asset is the amount which must be allocated on
a systematic basis over the asset’s estimated useful life. The amount of
depreciation expense is to be recognised in the profit and loss
statement.
The
amount of depreciation expense is dependant upon three factors:
-
estimating
the asset’s residual value;
-
estimating
the asset’s useful life; and
-
the choice of
depreciation method.
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Estimating the Asset’s Residual Value
First, an estimate must be made of the asset’s residual (or
disposal) value. Paragraph 6 of AASB 116 defines the residual value as:
“the estimated amount that an entity would
currently obtain from the disposal of the
asset, after deducting the estimated costs of disposal at the end of its
useful life”.
The estimate is based on the net amount that the entity could
recover for similar assets which have already reached the end of their
useful lives and have operated under similar conditions to those under
which the asset will be used.
The disposal value may be based on the asset’s scrap value or
on its expected trade-in value. If this value cannot be ascertained,
then a value of $Nil should be assigned. The residual value is also
known as the salvage value or trade-in value. The residual value of
every asset should be reviewed at least as the end of each financial
year and revised if necessary.
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Estimating the Asset’s Useful Life
Secondly, the asset’s estimated useful life must be
determined. Accordingly to paragraph 6 of AASB 116, an asset’s useful
life is defined as:
- The period over
which an asset is expected to be available for use by the entity; or
- The number of
production or similar units expected to be obtained from the asset
by an entity.
The useful life of an asset is expressed on a time basis
(usually in years). Paragraph 56 of AASB 116 states that in
determining the useful life of a depreciable asset, considerable
should be given to the following:
- Expected usage
of the asset;
- Expected
physical wear and tear;
- Technical or
commercial obsolescence; and
- Legal
or similar limits on the use of the asset.
Note that the definition of useful life refers to the
estimated useful life to the entity. This means that if a motor
vehicle has a physical useful life of eight years, but the owner of
the vehicle intends to dispose of the vehicle in five years’ time,
the useful life is five years, not eight years. The useful life of
every asset should be reviewed at least at the end of each financial
year and revised if necessary.
Practically, it is very difficult for bookkeepers,
accountants or the owners of the business to determine the useful lives
of assets.
For taxation purposes, the Commissioner of Taxation has
published its own determination of the useful lives of most depreciable
assets. These effective lives can be found in Taxation Ruling
TR2000/18 which can be downloaded from the Australian Taxation Office’s
website.
Most small businesses use these taxation rates for accounting
purposes.
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The Choice of Depreciation
Method
Introduction
AASB 116 prescribes three acceptable depreciation methods
that all result in the systematic allocation of the cost of the asset
over its useful life. These three methods are used:
-
the straight-line
method;
-
the reducing balance
method; and
-
the units of
production method.
AASB 116 does not specify a particular depreciation method to
be adopted by the entity. An entity has a choice of any of the three
abovementioned depreciation methods.
However, paragraph 60 of the standard states that the
depreciation method chosen must result in the best reflection of the
pattern in which the asset’s future economic benefits are expected to be
consumed by the entity.
The depreciation method should be reviewed at least at the
end of each financial year and changed if necessary. However, generally,
once an entity chooses a particular depreciation method for an asset, it
should apply this method consistently over the useful life of the asset.
All entities are required to disclose the depreciation method used in
the financial report.
Each of the depreciation methods are discussed in the
following paragraphs.
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Straight-line Method
The straight-line depreciation method results in an equal
amount of depreciation for each year in the asset’s useful life. Under
the straight-line method, depreciation expense is calculated by applying
the following formula:
(Cost – Estimated
residual value)
Estimated
useful life
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Reducing Balance Method
The reducing balance method is an example of an accelerated
depreciation method. It assumes that the asset will yield more service
potential in the earlier years than in the later years. Hence it
allocates greater amounts of depreciation in the earlier years of the
asset’s life than in the later years. Hence, it allocates greater
amounts of depreciation in the earlier years of the asset’s life than in
the later years. It does this by “weighting” or increasing the
straight-line depreciation by a percentage of 200%.
The formula for calculating the depreciation rate for the
reducing balance method is as follows:
RB rate =
100% x 200%
Useful life (in years)
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Units of Production Method
The units of production (or units of usage) depreciation
method allocates depreciation based on the physical use of the asset.
This method can only be used where the asset’s output can be measured
(either in tie or in number of units). For example, a machine may
produce a certain number of units of output per year or operate for a
certain number of machine hours per year.
The formula for calculation the depreciation under the units
of production method is as follows:
(Cost – Estimated residual value) = Depreciation per unit
Total estimated number of units
Depreciation expense
= Depreciation per unit x No. of units per year
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Comparison of Depreciation Methods
Facts: A photocopier is purchased in March 2006 for $10,000.
The following table compares the depreciation expense of the
photocopier using each of the three depreciation methods.
Year Straight-line
Reducing balance Units of Production
2006
$1,000
$1,800 $1,500
2007
$2,000
$3,060 $2,500
2008
$2,000
$2,142 $1,800
2009
$2,000
$1,499 $2,000
2010
$2,000
$1,050 $1,600
2011
$1,000
$499 $600
Total
$10,000 $10,000
$10,000
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