Methods of depreciation

By definition, fixed assets are those which will provide services over a number of years and the matching convention tells us that we should recognize the expense in the same period as we recognize the associated revenue. Thus we must not write off, or expense, the whole cost of the asset in the period in which the asset is acquired, but should instead convert the asset into an expense over its life. This gradual conversion is known as depreciation.

How should we compute the depreciation charge over each year? An obvious way would be to compare the current value of an asset at the end of the year with its value at the start of the year and say that the difference is depreciation. But as we have already emphasized, traditional accounting practice is based on historic cost and not current values; consequently that method is generally not acceptable. The traditional approach is to estimate the total expenditure to be written off, i.e. the cost of the asset less its estimated scrap value, and then to write off that expenditure over the estimated life of the asset by using one of the methods that we shall describe.

The life of the asset is usually measured in time, but in some instances may be measured on the basis of actual usage.

Depreciation on the basis of ‘actual usage’ is rare.

In order to consider the difficulties inherent in estimated life of an asset we should think about the reasons why most fixed assets, other than land, have a limited life. These reasons may be classified as physical wear and tear, and obsolescence. Obsolescence may be of the asset itself, e.g. a new machine may make the use of the original asset, an older machine, uneconomic, because the new machine is faster or requires less labor. Obsolescence may also be caused by the object produced by the asset, if, for example, it goes out of fashion. In the latter case, the degree of obsolescence will depend on the specific nature of the asset; some assets may be easily adapted to alternative uses while others may have only one use, the original.

None of the above variables can be determined with any accuracy; obsolescence, in particular, is rapidly increasing in importance because of rapid changes in technology.

Deciding how much should be written off and over what period is not the only problem, for there are a number of depreciation methods from which to choose. A firm’s management must decide which one to employ, and a user of financial statements who wishes to compare the financial performance of a number of companies must appreciate the effects of the various methods.

In practice we find two main methods of depreciation – the straight-line basis and accelerated depreciation. There is another method, the annuity method which takes account of the interest costs involved in investing in a long-live asset; this method has many theoretical attractions but is rarely used.