Property, plant and equipment (IAS 16) - Depreciation method...

Learning Outcomes

After reading this article, you will be able to explain the key requirements of IAS 16 regarding depreciation methods for property, plant and equipment. You will understand the main depreciation methods, know how to apply component depreciation, recognise how to account for changes in estimates and methods, and identify common exam pitfalls. This guides your preparation for ACCA Financial Reporting (FR).

ACCA Financial Reporting (FR) Syllabus

For ACCA Financial Reporting (FR), you are required to understand and apply the depreciation requirements of IAS 16. Ensure you are confident with the following syllabus points for this topic:

• The principles of depreciation under IAS 16 Property, Plant and Equipment
• The calculation and application of different depreciation methods: straight-line, reducing balance, and units of production
• The need for component depreciation and its accounting treatment
• How to identify and apply changes in depreciation method and changes in estimates
• The accounting treatment and disclosure of such changes
• Requirements for reviewing residual values, useful lives, and depreciation methods

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which of the following is an example of a depreciation method allowed by IAS 16?
   1. Reducing balance
   2. Sum of the years' digits
   3. Revaluation model
   4. Inventory turnover

2. True or false? A change from the straight-line method to reducing balance is treated as a change in accounting policy.

3. When might component depreciation be required by IAS 16?

4. Briefly state what actions must be taken when there is a revision of the useful life or residual value of an asset after initial recognition.

Introduction

Depreciation is the process of allocating the depreciable amount of property, plant and equipment (PPE) over their useful lives. IAS 16 sets out how entities should select and apply depreciation methods, deal with component parts, review estimates, and account for changes. For ACCA FR, it's essential to apply the correct methods and account for any required changes in depreciation, as this commonly appears in both computational and discursive exam questions.

Key Term: depreciation
The systematic allocation of the depreciable amount of an asset over its useful life.

Key Term: depreciable amount
The cost of an asset, or other amount substituted for cost, less its residual value.

Key Term: component depreciation
The separate depreciation of significant parts of an asset with different useful lives or consumption patterns.

Key Term: change in accounting estimate
An adjustment of the carrying amount of an asset resulting from new information or new developments, including changes in useful life, residual value, or depreciation method.

DEPRECIATION METHODS UNDER IAS 16

IAS 16 requires that the depreciation method used should reflect as closely as possible the pattern in which the asset's future economic benefits are expected to be consumed by the entity.

Entities may use the following depreciation methods:

• Straight-line method: Allocates an equal amount of depreciation each period over the asset's useful life.
• Reducing balance method: Charges higher depreciation in the earlier years and less in later years.
• Units of production/machine hours method: Allocates depreciation based on actual usage.

IAS 16 does not prescribe a specific method but requires that once selected, it should faithfully represent the asset's consumption pattern.

Worked Example 1.1

Sonic Co acquired a delivery van on 1 January 20X7 for $48,000. The van's estimated useful life is 6 years and the residual value is $6,000. Calculate the annual depreciation charge for:

a) The straight-line method

b) The reducing balance method at 25%

Answer:

a) Straight-line: Depreciable amount = $48,000 – $6,000 = $42,000; Useful life = 6 years. Depreciation per year = $42,000 ÷ 6 = $7,000.

b) Reducing balance: First year: $48,000 × 25% = $12,000; following years are 25% of the reduced carrying amount.

Component Depreciation

Where an item of PPE is made up of significant parts with different useful lives or consumption patterns, each part (component) should be depreciated separately.

Exam Warning Many candidates lose marks by failing to depreciate significant components separately. The FR exam may require you to identify and calculate depreciation for such components individually.

Worked Example 1.2

A company acquires a machine for $110,000, which consists of a $10,000 control panel (5-year life), and the main structure ($100,000, 10-year life). The machine has no residual value. What are the depreciation charges for each component?

Answer:

Control panel: $10,000 ÷ 5 = $2,000 per year

Main structure: $100,000 ÷ 10 = $10,000 per year

Total annual depreciation: $2,000 + $10,000 = $12,000

REVIEW OF USEFUL LIFE, RESIDUAL VALUE AND METHOD

IAS 16 requires that the useful life, residual value, and depreciation method be reviewed at least annually. If expectations differ from previous estimates, these changes are treated as changes in accounting estimate, not as changes in accounting policy.

• Any change is applied prospectively from the date of the change.

Revision Tip If you are told in an exam that an asset's useful life or residual value is revised, do not restate prior years. Calculate depreciation going forward based on the revised estimates.

Worked Example 1.3

Delta Ltd bought equipment for $50,000 on 1 April 20X5 (no residual value, 10-year straight-line). After four years, on 31 March 20X9, it reviews the useful life and now expects a further 8 years of use (12 years total). What is the depreciation charge for the year ended 31 March 20X10?

Answer:

Depreciation for first 4 years: $50,000 ÷ 10 = $5,000/year, total $20,000.

Carrying amount at 31 March 20X9 = $50,000 – $20,000 = $30,000.

Revised useful life from 31 March 20X9 = 8 years.

New depreciation charge: $30,000 ÷ 8 = $3,750 per year from 20X10 onwards.

CHANGES IN DEPRECIATION METHOD OR ESTIMATES

Changing the method of depreciation (e.g., moving from straight-line to reducing balance) is only permitted if the revised method provides a more reliable and relevant reflection of the asset's consumption of benefits.

• Such a change is regarded as a change in estimate, not as a change in accounting policy.
• The new method is applied prospectively from the period of change.

Exam Warning Do not restate comparative figures when changing depreciation method or revising estimates. Only adjust current and future periods.

Worked Example 1.4

Nash Ltd depreciates its vehicles using the straight-line method over 5 years but decides in year 3 to change to the reducing balance method at 40% because this better matches usage. The vehicle cost $20,000 (no residual value) and was purchased 2 years ago. What is the depreciation charge in year 3?

Answer:

Years 1–2 (straight-line): $20,000 ÷ 5 = $4,000 per year.

After 2 years: Carrying amount = $20,000 – $8,000 = $12,000.

Year 3 (reduce balance): $12,000 × 40% = $4,800.

DISCLOSURE REQUIREMENTS

IAS 16 requires entities to disclose:

• The measurement basis used for determining the gross carrying amount
• The depreciation methods used
• Useful lives or depreciation rates
• The gross carrying amount and accumulated depreciation
• Reconciliation of the carrying amount at the beginning and end of the period
• The amount of depreciation charged in the period
• The nature and effect of any changes in estimate affecting depreciation

Summary

Depreciation allocates the depreciable amount of an asset over its useful life using a method reflecting its pattern of consumption. IAS 16 permits straight-line, reducing balance, and usage-based methods, as long as the chosen method best represents how economic benefits are used. Component depreciation is required when parts of an asset have different useful lives. Any changes in method or estimates are treated as changes in estimate and are applied prospectively, not retrospectively.

Key Point Checklist

This article has covered the following key knowledge points:

• Define depreciation and depreciable amount according to IAS 16
• Identify and apply the main depreciation methods permitted
• Recognize when component depreciation is required and how to apply it
• Explain annual review requirements for useful life, residual value, and depreciation method
• Account for changes in depreciation method or estimate as prospective changes in estimate
• List IAS 16's required disclosures for depreciation and changes in estimate

Key Terms and Concepts

• depreciation
• depreciable amount
• component depreciation
• change in accounting estimate