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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:

a. Estimating the asset’s residual value;
b. Estimating the asset’s useful life; and
c. The choice of depreciation method.

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.

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.

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:

a. The straight-line method;
b. The reducing balance method; and
c. 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.

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

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)

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

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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