Depreciation and amortisation are systematic allocation of the depreciable amount of an asset over its useful life. Depreciation and amortisation are usually recognised as an expense in P/L, but they can also be included in the carrying amount of another asset. This happens when the future economic benefits embodied in an asset are absorbed in producing other assets, such as inventory (IAS 16.48-49).
Depreciation vs amortisation
Depreciation is a term used with reference to property, plant and equipment (‘PP&E’), whereas amortisation is used with reference to intangible assets. Depreciation of PP&E is governed by IAS 16, whereas amortisation of intangible assets is set out in IAS 38. Requirements of these two standards mostly overlap with a few notable exceptions that are discussed specifically where applicable. Otherwise, all of the discussion on this page applies equally to property, plant and equipment and to intangible assets.
Depreciable amount is the cost of an asset less its residual value. Depreciation is recognised even if the fair value of the asset exceeds its carrying amount, as long as the asset’s residual value does not exceed its carrying amount (IAS 16.52,54).
The residual value of an asset is the estimated amount that an entity would currently obtain from disposal of the asset, after deducting the estimated costs of disposal, if the asset was already of the age and in the condition expected at the end of its useful life (IAS 16.6). Consequently, an increase in the expected residual value of an asset because of past events will affect the depreciable amount, but expectations of future changes in residual value other than the effects of expected wear and tear will not (see also the discussion in IAS 16.BC29).
In most cases, the residual value is insignificant and an asset is depreciated until its carrying amount reaches zero (IAS 16.53). Additionally, IAS 38 makes a rebuttable presumption that the residual value of an intangible asset should be assumed to be zero unless one of the criteria set out in paragraph IAS 38.100 are met.
Depreciation starts when the asset is in the location and condition necessary for it to be capable of operating in the manner intended by management. This is the same moment up to which directly attributable costs can be recognised as a part of the cost of PP&E. An asset is depreciated over its useful life, which is the period over which an asset is expected to be available for use by the entity (IAS 16.6).
Useful life should be entity-specific and can be much shorter that the useful life that would be determined by others. It depends on the activity profile of an entity and its asset management policy (IAS 16.57). Useful life can be also expressed in the number of production or similar units expected to be obtained from the asset. Paragraph IAS 16.56 lists factors that should be considered in determining the useful life of an asset.
See also accounting for assets acquired in a business combination that the acquirer does not intend to use.
Useful life and amortisation period of intangible assets
IAS 38 requires an entity to determine whether the useful life of an intangible asset is finite or indefinite. An intangible asset is regarded by the entity as having an indefinite (not the same as infinite) useful life when there is no foreseeable limit to the period over which the asset is expected to generate net cash inflows for the entity (IAS 38.88). The significance of this distinction is that intangible assets with indefinite useful life are not amortised. Paragraphs IAS 38.90-96 contain more guidance for making such a distinction, including taking into account only those renewals that can be made without significant cost.
Typical examples of assets with indefinite useful lives include: well established brands, licences for infinite period or with renewals without significant cost.
Examples of assets that normally have finite useful lives include: all kinds of rights for finite period (e.g. licences, patents), software, know-how, recently developed brands, customer relationships.
Intangible assets with finite useful lives are amortised over their useful lives. Requirements for amortisation period and amortisation method are set out in paragraphs IAS 38.97-99 and generally are the same as in IAS 16.
An intangible asset with an indefinite useful life is not amortised. Instead it should be tested for impairment at least annually under IAS 36 (IAS 38.107-108). Additionally, the assessment of whether an intangible asset has indefinite useful life should be reviewed at each reporting date (IAS 38.109-110).
See also Examples 4-9 accompanying IAS 38.
See also accounting set out in IFRS 3 for assets acquired in a business combination that the acquirer does not intend to use.
Choosing depreciation method
The depreciation method should allocate the depreciable amount of an asset on a systematic basis over its useful life and reflect the pattern in which the asset’s future economic benefits are expected to be consumed by the entity (IAS 16.60). The most popular depreciation methods are:
- straight-line method,
- diminishing balance method and
- units of production method.
However, an entity may apply its own method that best reflects the consumption of economic benefits of an asset.
Straight-line method is by far the most popular method of depreciation. As it name implies, depreciation charge is spread evenly over the useful life of an asset. It is suitable for the majority of assets.
Diminishing balance method
Under the diminishing balance method (often referred to as reducing balance method), the depreciation charge decreases over time as it is calculated with reference to carrying value at the beginning of the current period, instead of the original cost. This method is used for depreciating assets subject to increased technical or commercial obsolescence.
There are a few approaches to the mechanics of this method. In general, the essence of this method is that a depreciation rate is applied to net book value (carrying amount) of the asset instead of its original cost (as is the case under the straight line method). When there is a residual value of the fixed asset, entities can apply the same depreciation rate during the useful life. This depreciation rate can be calculated using the goalseek function in excel (an illustrative excel file can be found in the example below). When there is no residual value, it is much harder to get to zero at the end of useful life using the same depreciation rate applied to net book value for the whole depreciation period. In such cases, the diminishing balance method switches to straight line method when the depreciation charge under straight line method is higher than would be under diminishing balance method.
The following examples illustrate these two approaches to diminishing balance method.
Entity purchased, for $12 million, an item of high-tech PP&E subject to increased technical obsolescence. The entity assesses that the asset will be used for 5 years, with most of its performance utilised in the first years. The residual value is $2 million. The depreciation is calculated using the diminishing balance method as presented below. Note that depreciation rate is calculated using the goal seek function. You can download an excel file for this example.
|Year||Net book value||Depreciation charge|
Entity purchased the same asset as in the example above, but this time the residual value is zero. You can download an excel file for this example.
Rate for diminishing balance depreciation: 30%
Rate for straight line depreciation: 20%
Cost of PP&E: 12
Depreciation charge under straight line depreciation: 2.4
Note: you can scroll the table horizontally if it doesn’t fit your screen
|Year||Net book value||Depreciation charge|
|1||12.00||3.60||@ diminishing balance rate|
|2||8.40||2.52||@ diminishing balance rate|
|3||5.88||2.40||@ straight line rate|
|4||3.48||2.40||@ straight line rate|
|5||1.08||1.08||@ straight line rate (until NBV = 0)|
Sum of the digits depreciation
Sum of the digits depreciation is similar in effect to diminishing balance method. Its application is illustrated in the following example.
In this example we use the same item of high-tech PP&E purchased for $12 million with no residual value. This asset will be used for 5 years. Entity recognises depreciation expense using sum of the digits method as follows:
Year 1: (5/15) x $12m = $4m
Year 2: (4/15) x $12m = $3.2m
Year 3: (3/15) x $12m = $2.4m
Year 4: (2/15) x $12m = $1.6m
Year 5: (1/15) x $12m = $0.8m
Total: (15/15) x $12m = $12m
You can download an excel file with these calculations.
Units of production method
In this method, the depreciation is based on the expected use or the output of an asset. Depreciation charge for a period reflects the share of total expected use/output consumed during that period.
A depreciation/amortisation method that is based on revenue that is generated by an activity that includes the use of an asset is allowed, in limited circumstances, for intangible assets only, as explained in paragraphs IAS 38.98A-C. This is because revenue is affected by other inputs and processes, selling activities and changes in sales volumes and prices (IAS 16.62A).
Depreciation based on tax allowances
Some entities depreciate assets based on what is the available depreciation tax allowance determined by the tax law for a particular asset. This approach can be adopted for financial reporting under IFRS only if such a depreciation also reflects the pattern in which the asset’s future economic benefits are expected to be consumed by the entity. Extra care is needed when the tax law promotes expenditures on certain types of assets by allowing accelerated depreciation for tax purposes. In such cases, tax depreciation rates will hardly ever faithfully reflect the pattern in which the asset’s future economic benefits are expected to be consumed by the entity.
Separate depreciation of significant parts of PP&E
General requirement for separate depreciation of significant parts of PP&E
Each part of an item of PP&E with a cost that is significant in relation to the total cost of the item should be depreciated separately (IAS 16.43-47). Example given by IAS 16.44 uses airframe and engines of an aircraft that should be depreciated separately.
IAS 38 did not introduce separate amortisation of significant parts of an intangible asset.
Land and buildings
A particular aspect of separate depreciation concerns land and buildings. It is often not possible to legally separate buildings from land on which they are located. However, they should be treated as separate assets and separately considered for depreciation purposes. Land has unlimited useful life (with limited exceptions) and should not be depreciated. Buildings should also be separated from land when determining residual values, therefore increase in value of land should not affect depreciation of buildings (IAS 16.58).
In some cases, the cost of land includes decommissioning costs. These costs are depreciated over the period of benefits obtained by incurring those costs, e.g. until the restoration is expected to take place (IAS 16.59).
Depreciation of unused assets
As stated before, depreciation starts when the asset is in the location and condition necessary for it to be capable of operating in the manner intended by management. When an asset is not used during the period, it is still depreciated unless the units of production method is applied to that asset (IAS 16.55). Depreciation charge for that period reflects the consumption of the asset’s service potential that occurs while the asset is held (IAS 16.BC31). Such ‘idle’ periods occur usually just after the asset is acquired/developed and just before it is disposed of. Note that assets that fall under the scope of IFRS 5 are not depreciated.
Changes in estimates
The residual value, the useful life and the depreciation method should be reviewed at least at each financial year-end (IAS 16.51,61; IAS 38.104-106) with any changes accounted for prospectively under IAS 8 as changes in accounting estimates.
More about IAS 16 and 38
See other pages relating to IAS 16 and IAS 38:
IAS 16 Property, Plant and Equipment: Scope, Definitions and Disclosure
IAS 38 Intangible Assets: Scope, Definitions and Disclosure
IAS 16: Cost of Property, Plant and Equipment
IAS 38: Recognition and Cost of Intangible Assets
IAS 16 and IAS 38: Depreciation and Amortisation of Property, Plant and Equipment and Intangible Assets
IAS 16 and IAS 38: Revaluation Model for Property Plant and Equipment and Intangible Assets