The straight-line method
This method is based on the cost of a property plant and equipment cost uniform distribution during its useful life.
That is, in this method, it is irrelevant if an entity uses the asset in a greater proportion in one year than in another.
In general, this type of method is used in assets in which the generation of future economic benefits is presumed to be similar throughout the useful life of an asset.
Some examples of assets that use this method are buildings, bridges, roads, and warehouses, among others.
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The straight-line method example
Let’s consider the following example.
In January of year 1; a company buys a building for 15,000,000 with a useful life of 50 years and a salvage value of 20%.
What would the depreciation charge be at the end of year 10?
To perform depreciation calculation, first, we must find the depreciable amount.
Depreciable amount = Cost of an asset – residual value
It is important to remember that residual value is the amount that a company expects to receive from the sale of an asset after a certain period of use.
Depreciable amount = 15,000,000 – 3,000,000 (15,000,000 x20%)
Depreciable amount = 12,000,000
Annual depreciation = (9,100,000 / 50 years) = 240,000
Accumulated depreciation = Depreciable amount / Useful life X elapsed time
Accumulated depreciation = (12,000,000 / 50 years) x 10 years
Accumulated depreciation = 1,920,000
Carrying amount Asset year 8 = asset cost – accumulated depreciation
Carrying amount Asset year 8 = 15.000.000 – 1,920,000
Carrying amount Asset year 8 = 13,080,000
On the other hand, assets that use this method have the peculiarity that even if they are not in use, their depreciation must continue, as set out in paragraph 55 of IAS 16.
Something very different occurs in assets that use the units of production method since the generation of economic benefits associated with the asset is not based on its use but on its production.
Units of production method
In this method, the asset’s ability to generate economic benefits is proportional to its production; in other words, the longer a company demands the services of this type of asset, the depreciation charge will tend to increase.
Usually, this method is used in companies with equipment or machines to produce goods.
Let’s analyze the example shown below.
Units of production method example
A company producing diapers acquires in January of year one a machine by 15,000,000.
This asset can produce 200,000 units throughout its useful life.
According to estimates made by the company’s management, the units produced in the next four years are expected to be as follows:
Year 1: 50,000
Year 2: 45,000
Year 3: 75,000
Year 4: 30,000
What is the depreciation charge for the next four years?
Depreciation year 1: (15.000.000 /200.000) X 50.000 = 3.750.000
Depreciation year 2: (15.000.000 / 200.000) X 45.000 = 3.375.000
Depreciation year 3: (15.000.000 / 200.000) X 75.000 = 5.625.000
Depreciation year 4: (15.000.000 / 200.000) X 30.000 = 2.250.000
The diminishing balance method
If a company considers that its assets will tend to become obsolete over time, the diminishing balance method is ideal for this type of asset.
This is so because the economic behavior of this type of property, plant, and equipment is that the generation of economic benefits will be higher in the first years of use.
After this, the curve of the generation of benefits will decrease as time passes.
Let’s analyze the following example.
The diminishing balance method example
A company acquires a machine that manufactures plastic containers for 15,000,000.
The entity estimates that the decreasing depreciation rate is 40% on the asset balance.
The entity’s management decided to use this method because it expects that the demand for plastic containers will decrease over time because, in the country in which the entity operates, a regulation will soon be issued that prohibits the use of this material.
The company expects that in 4 years, the demand for plastic will have decreased considerably, during which time the entity will sell this machine to another country for 3,000,000.
The depreciation charge and the carrying amount of the asset for the next four years are as follows:
Carrying amount: 15.000.000
Residual value: 3.000.000
Depreciable amount: 12.000.000 (15.000.000 – 3.000.000)
Depreciation rate: 40%
Depreciation year 1: 4.800.000 (12.000.000X40%)
Carrying amount year 1: 10.200.000 (15.000.000 – 4.800.000)
Depreciable amount year 2: 7.200.000 (10.200.000 – 3.000.000)
Depreciation year 2: 2.880.000 (7.200.000×40%)
Carrying amount year 2: 7.320.000 (10.200.000 – 2.880.000)
Depreciable amount year 3: 4.320.000 (7.320.000 – 3.000.000)
Depreciation year 3: 1.728.000 (4.320.000×40%)
Carrying amount year 3: 5.592.000 (7.320.000 – 1.728.00)
Depreciable amount year 4: 2.592.000 (5.592.000 – 3.000.000)
Depreciation year 4: 1.036.000 (2.592.0000×40%)
Carrying amount year 4: 4.556.000 (5.592.000 – 1.036.000)
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