10.2.3: Methods of Calculation

The IFRS requirement of allocation of cost on a systematic basis is a deliberately vague description of the techniques used to calculate depreciation. Companies are given the freedom to choose the method used, as long as the method makes sense in relation to the consumption of future economic benefits realized by use of the asset. The standard does identify three broad techniques that can be used: straight line, diminishing balance, and units of production. However, other techniques could be justified if they provide a more systematic and reasonable allocation of cost. The standard also indicates that depreciation methods based on revenue should not be used, as revenue may be affected by factors, such as inflation, that are not directly related to the consumption of economic benefits.

Straight-Line Method

This is the simplest and most commonly used depreciation method. This method simply allocates cost in equal proportions to the time periods of an asset's useful life. The formula to determine the depreciation charge is as follows:

For example, consider an automated packaging machine purchased for $100,000 that is used in a factory. It is estimated that this machine will have a useful life of ten years and will have a residual value of $5,000. The calculation of the annual depreciation charge is as follows:

The benefit of this method is its simplicity for both the preparer and reader of the financial statement. No special knowledge is required to understand the logic of the calculation. As well, the method is appropriate if we assume that economic benefits are delivered in roughly equal proportions over the life of the asset. However, there are arguments that are contrary to this assumption. For certain assets, it may be reasonable to assume that the economic benefits decline with the age of the asset, as there is more downtime due to repairs or other operational inefficiencies that result from age. If these inefficiencies are significant, then the straight-line method may not be the most appropriate method.

Diminishing-Balance Method

The diminishing-balance method results in more depreciation in the early years of an asset's life and less depreciation in later years. The justification for this method is that an asset will offer its greatest service potential when it is relatively new. Once an asset ages and starts to require more repairs, it will be less productive to the business. This reasoning is quite consistent with the experience many companies have with assets that have mechanical components. This method will also result in an overall expense to the company that is fairly consistent over the life of the asset. In early years, depreciation charges are high, but repairs are low; in later years, this situation will reverse.

A number of different calculations can be used when applying the diminishing-balance method. The common feature of all the methods is that a constant percentage is applied to the closing net book value of the asset each year to determine the depreciation charge. The percentage that is used can be derived in a number of ways. The most accurate way would be to apply a formula to determine the exact percentage needed to depreciate the asset down to its residual value. Although this can be done, this approach is not often used, because it requires a more complex calculation. A simpler, more commonly used approach is to simply use a multiple based on the asset's useful life. For example, a technique referred to as double-declining balance would convert the useful life to a percentage and multiply the result by two. In our previous example, the calculation would be as follows:

Depreciation would thus be calculated as follows:

Year	Book Value,	Rate	Depreciation	Accumulated	Book Value,
	Opening		Expense	Depreciation	Closing
1	100,000	20%	20,000	20,000	80,000
2	80,000	20%	16,000	36,000	64,000
3	64,000	20%	12,800	48,800	51,200
4	51,200	20%	10,240	59,040	40,960
5	40,960	20%	8.192	67,232	32,768
6	32,768	20%	6,554	73,786	26,214
7	26,214	20%	5,243	79,029	20,971
8	20,971	20%	4,194	83,223	16,777
9	16,777	20%	3,355	86,578	13,422
10	13,422	20%	8,422*	95,000	5,000

*Note: In the final year, depreciation does not equal the calculated amount of net book value multiplied by depreciation percentage (). In the final year, the asset needs to be depreciated down to its residual value. The double-declining balance method will not result in precisely the right amount of depreciation being taken over the asset's useful life. This means that the final year's depreciation will need to be adjusted to bring the net book value to the residual value. Depending on the useful life of the asset, this final-year depreciation amount may by higher or lower than the amount calculated by simply applying the percentage. Because depreciation is an estimate based on a number of assumptions, this type of adjustment in the final year is considered appropriate.

Also note that in the calculations above, unlike other methods, the residual value is not deducted when determining the depreciation expense each year. The residual value is considered only when adjusting the final year's depreciation expense.

Units-of-Production Method

This method is the most theoretically supportable method for certain types of assets. The method charges depreciation on the basis of some measure of activity related to the asset. The measures are often output based, such as units produced. They can also be input based, such as machine hours used. Although output-based measures are the most accurate way to reflect the consumption of economic benefits, input-based measures are also commonly used. The benefit of this method is that it clearly links the actual usage of the asset to the expense being charged, rather than simply reflect the passage of time. Returning to our example, if the machine were expected to be able to package 1,000,000 boxes before requiring replacement, our depreciation rate would be calculated as follows:

Thus, if in a given year, the machine actually processed 102,000 boxes, the depreciation charge for that year would be as follows:

In years of high production, depreciation will increase; in years of low production, depreciation will decrease. This is a reasonable result, as the costs are being matched to the benefits being generated. However, this method is appropriate only where measures of usage are meaningful. In some cases, assets cannot be easily measured by their use. An office building that houses the corporate headquarters cannot be easily defined in terms of productive capacity. For this type of asset, a time-based measure would make more sense.