In a previous article “List of fixed asset depreciation calculation software” a list of software was provided that caters to depreciation calculation. Today we will be looking more specifically at depreciation as it would typically apply to different classes of assets.
Before looking at appropriate depreciation rates, we need to first discuss the theory and reasoning behind the need for depreciation calculation in order to give you a better understanding of the overall objective of doing depreciation calculation.
The guidelines of generally accepted accounting practices globally require accountants to comply with some principles, and one of them is the matching principle. This would mean that an accountant cannot show income this year that is not yet earned.
Let’s take a very simplistic example to illustrate the concept. If for example a 5-year contract has been allocated and money is received in advance by an organization, only the income that pertains to what is earned in the first year would be allocated within the Income Statement for that first year, regardless of when the cash was physically received. Cash received in advance of it being earned, or cash received only after it had been earned, will not impact on when the income will be accounted for in the Income Statement.
The matching principle will require now of the accountant to match the expenses that relate to that particular income for that year accordingly, regardless of which year cash was spent. In a simplistic example, if the company only did this one project, that was to stretch over 5 years and bought assets in order to earn this income, the expenses would be matched with regards to its contribution to income over the 5 years.
Say in this example that all the assets were bought on the first day of the project and all the assets lasted exactly 5 years and contributed day to day in exactly the same way towards the project, in such a case all the assets would have been taken to the Balance Sheet at day 1, but at the end of the year one, 20% of its value would have been transferred to the Income Statement as an expense with the name “depreciation”. Each following year another 20% of the Balance Sheet value of fixed assets would have been transferred to the Income Statement and at the end of the 5 years, the Balance sheet will have a book value of zero for all assets.
In real life, however, the expected lifespan of various assets is different from one category to another, and thus the initial price of the asset needs to be spread accordingly, in order to comply with the matching principle. IT equipment typically has an expected life span of 3 years and therefore it is typically depreciated over 3 years exactly, which is 33.3% per year. Furniture is expected to last longer, perhaps 5 years, and would therefore be more likely to be depreciated at 20% per year.
All assets, however, aren’t expected to contribute in the same way each year, and some are expected to lose their value gradually over a long time. In such a case it would be more appropriate to depreciate those assets not on the cost price, but on the book value. This will imply that the assets can stay many years with a book value on the Balance Sheet, with smaller and smaller portions of it being “expensed” to the Income Statement year upon year.
We have covered now some of the theories behind depreciation. In practice, many accountants skip this process of assessing their assets based on their expected lifespan and contribution to income and simply look at what the taxman would allow them to deduct as wear and tear per category each year. This may simplify their tax calculations as it would result in a smaller difference between actual profit and taxable profit, although this is technically not the correct way of doing this. Also, note that tax allowances may differ from one country to another.
In light of all the above, it is not possible to give a setlist of prescribed depreciation rates per asset category, but it is possible to give some general guidelines. Companies who already have a fixed asset policy as indicated on their Financial Statements should continue depreciating in line with that policy unless something fundamental changes within the organization. This is important in order to ensure consistency, which is another generally accepted accounting practice principle that accountants need to adhere to.
Although the straight-line method of depreciation (writing assets off at a fixed % per year on the original cost price) and the book value method of depreciation (writing assets off at a fixed % based on the latest book value of the assets in the Balance Sheet) are popular methods of depreciation, there are other methods also available.
IT equipment would often be expected to last 3 years. If the cost price is spread exactly over 3 years this would result in a 33.3% depreciation p.a.
Furniture would often be expected to last 5 years. If the cost price is spread exactly over 5 years this would result in a 20% depreciation p.a.
Equipment would often be expected to last 4 years. If the cost price is spread over 4 years this would result in a 25% depreciation p.a.
Books and very small assets are typically expected to contribute to the income of the organization only in the year it was bought and would often be taken directly to the Income Statement in that year.