Depreciation is the systematic allocation of the depreciable amount of a fixed asset over its useful life. A fixed asset is recognized in the books of accounts when:
- The business expects future economic benefits from the purchase of the plant, property & equipment,
- The cost of the asset can be measured reliably.
Depreciation should be charged on the asset from the time the asset is available for use. A variety of depreciation methods can be used to determine the depreciation amount of an asset on a systematic basis over its useful life, as per IAS 16 the following methods of depreciation can be followed by an entity:
- Straight Line method – In this method, a fixed % or amount is charged every accounting period, irrespective of the carrying value. The % is calculated on the acquisition value.
- Diminishing Balance method – In this method, the depreciation is calculated on the carrying value of assets rather than the acquisition value. As a result, the depreciation charged in the initial years would be higher than the depreciation charged in subsequent years.
- The units of production method – In this method, depreciation would be charged based on the output that the asset could produce. This method is typically used for Plant and machinery where the usage can be quantified in terms of numbers or hours.
Selecting the right depreciation method is important to ensure that there is no inflation or deflation of the profits due to inadequate depreciation methods. Once a particular method is being followed to depreciate an asset, it should be continued and not changed, which is called the Consistency Concept of Accounting. A change in the accounting principle should be only for the following reasons:
- Change in method ensures the better presentation of the Financial statements
- To follow legal obligations
- There is a significant effect on the books of accounts.