The amount of depreciation charged on a tangible asset depends on certain important factors relating to the cost, expected residual value, useful life, and allocation of the asset’s cost. These factors are considered to determine the depreciation expense to be recognised during each accounting period.
Depreciation should generally be allocated in a rational and systematic manner over the useful life of an asset. Therefore, proper estimation of the factors affecting depreciation is necessary for the systematic allocation of the asset’s cost.
Cost of the Asset
The cost of the asset is one of the primary factors for determining depreciation. It represents the amount paid to acquire the asset and generally includes all costs related to acquiring the asset and bringing it into use.
Therefore, the cost of an asset may include more than its basic purchase price. Costs associated with acquiring the asset and making it ready for use form part of the total asset cost.
The cost of the asset provides the starting point for determining the amount to be allocated as depreciation over its useful life.
Expected Salvage Value or Residual Value
The salvage value, also known as residual value, is the expected value of an asset at the end of its useful life.
The expected residual value is considered while determining the amount of asset cost that is to be allocated through depreciation. It represents the value expected to remain after the asset has completed its useful period of service.
In some countries or for certain accounting purposes, the salvage value may be ignored. The treatment of residual value may therefore depend on the applicable accounting or other relevant rules.
Estimated Useful Life of the Asset
The estimated useful life of an asset is the period during which the asset is expected to provide economic benefits to the business.
Assets are classified into different classes, and each class may have a different useful life. For example, different types of equipment and other tangible assets may provide benefits for different periods.
In many cases, the useful life of an asset is estimated on the basis of business experience. However, the rules of some countries may specify the useful lives to be used for particular categories of assets.
The estimated useful life determines the period over which the depreciable cost of an asset is allocated.
Method of Apportioning Cost
The method of apportioning the cost of an asset over its useful life is another important factor affecting depreciation.
Depreciation is a method of allocating asset cost to the accounting periods in which the organisation is expected to benefit from the use of the asset. Therefore, an appropriate method is required to distribute the depreciable cost over the estimated useful life.
The selected method determines the manner in which depreciation expense is allocated among different accounting periods.
In some countries, accounting or other applicable rules may prescribe particular depreciation methods for specific types of assets. In other cases, the business may select a method from the acceptable depreciation methods available.
Depreciable Basis
The depreciable basis represents the cost of the asset that is subject to allocation over its useful life.
The cost generally includes the amount paid for the asset and the costs relating to its acquisition and bringing it into use. The expected salvage or residual value may also be considered in determining the amount to be depreciated.
Thus, the depreciable basis is influenced mainly by the cost of the asset and the treatment of its expected residual value.
Business Experience and Applicable Rules
Business experience may influence the estimation of an asset’s useful life and the selection of an appropriate method of depreciation.
In most cases, the useful life of an asset may be estimated on the basis of the entity’s experience regarding the use of similar assets.
However, the rules of certain countries may prescribe specific useful lives and depreciation methods for particular categories of assets. Therefore, applicable accounting or other relevant rules may also affect the determination of depreciation.
Exam Focus
The four main factors considered for depreciation are the cost of the asset, expected salvage or residual value, estimated useful life of the asset, and the method of apportioning the cost over its useful life.
The cost of an asset generally includes the amount paid for the asset and all costs related to acquiring and bringing the asset into use. Residual value is the expected value of the asset at the end of its useful life.
The useful life determines the period over which the asset’s cost is allocated, while the method of apportionment determines how depreciation expense is distributed among accounting periods.
Depreciation should be allocated in a rational and systematic manner over the useful life of the depreciable asset.