Poor depreciation techniques can distort accounts


The short life-span and upgradeability of many IT assets complicate the otherwise fairly simple concept of depreciation. In this article, Michael Blackstaff explains the pros and cons of different depreciation methods.
Take any dozen organizations and you will find as many different approaches to the depreciation of IT assets. Some methods cause an artificially high or low charge to the profit and loss account and to budgets in the year of acquisition.
Some approaches to the depreciation of upgrades have the effect of causing depreciation 'peaks', either in the middle or at the end of life of the upgradeable range.
Depreciation is an accounting technique for charging the cost of a fixedasset as an expense to the profit and loss accounts of the years that benefit from its use. The expense reduces both the profit and the book value of theasset.
When the asset is eventually sold, the proceeds of sale are deducted from its book value. Any remaining amount is charged to the profit and loss account as a loss or (very rarely) profit on disposal.
Depreciation is governed by accounting standards. The gist of the rules is that the cost of an asset, less its expected residual value, should be depreciated over its expected useful economic life.

The standards do not require any particular method of depreciation to be adopted. This, and the estimated life of the asset, is left to be determined by the business person.
'Straight line' depreciation
The 'straight line' method charges the cost of the asset, less any expected proceeds of sale, in equal amounts over the asset's expected useful economic life.
It is easy to use, and reflects the fact that the usefulness of most assets is much the same for each year of their economic lives. Its main disadvantage is that it does not usually reflect the true decline in market value of an asset over its life.

Although the book value of assets does not have slavishly to reflect their market value, any significant difference between the two leads to a 'loss on disposal' when the asset is disposed of (see above).
The straight-line method, combined with a frequent tendency to overestimate asset life, makes this a common problem. However, it has the merit of simplicity, and despite its drawbacks, the majority of businesses, at least in the UK, use straight-line depreciation.

Reducing balance depreciation
Using this approach, a fixed percentage rate, for example 40%, is charged as depreciation each year on the reducing balance. This method reflects more closely the decline in market value of most assets, and is also easy enough to use.
Its main problem is the fact that it results in a higher charge in the first year than the straight-line method. A higher charge to the profit and loss account means less profit, and a higher charge against a departmental budget means less money for other things.
However, the higher the depreciation charge early in an asset's life, the less likely is a substantial loss on eventual disposal.

Frequency of depreciation charge
Most companies charge depreciation monthly from the date of acquisition of an asset, or sometimes from the date of first productive use. Some, however, still adopt the approach of charging a full year's depreciation in the accounting year of acquisition, regardless of when in that year they are acquired.


This may be fine for assets having a long life of, say, 20 years or more, but many of today's IT assets have very short lives in some companies.

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