When companies incur an expense, they record it in the income statement for that year. However, the same does not apply to costs borne on assets. More specifically, when companies acquire fixed assets, they cannot charge it as an expense. Instead, they must spread these costs until they use those assets. For that, they must calculate the depreciable value.
What is Depreciation?
Depreciation is a method through which companies spread the cost of their fixed assets. Under IAS 16, companies cannot charge that cost to the income statement directly. Instead, they must use depreciation to divide those costs over the asset’s useful life. Companies can use several approaches to apply that. Nevertheless, the principle remains the same.
Depreciation allows companies to match their expense with the revenues they help generate. This approach falls in line with the matching principle in accounting. This way, companies can spread the asset’s cost over the period in which they contribute to revenues. However, the process requires companies to calculate the depreciable value of that asset first.
What is the Depreciable Value of an asset?
The depreciable value of an asset may include its cost only. However, accounting standards require companies to account for its salvage value before that. Salvage value represents the book value of an asset after a company fully depreciates it. Companies must deduct this value from the asset’s cost before deprecating it. Consequently, the residual amount represents the asset’s depreciable value.
The depreciable value of an asset allows companies to calculate its depreciation amount accurately. By deducting the salvage value, companies only depreciate the asset’s value that they use. Usually, the salvage value is recoverable by disposing of the asset. Therefore, companies must not include it in depreciation calculations. In some cases, fixed assets may not have a salvage value, thus, making their cost equal to the depreciable value.
How to calculate the Depreciable Value of an asset?
Calculating the depreciable value of an asset requires two components, namely its cost and salvage value. Usually, the former includes the purchase consideration, taxes, registration fees, duties, etc. Companies calculate the cost of an asset using the guidelines set by IAS 16. Once companies reach that cost, they must deduct the salvage value.
As mentioned, the salvage value is an asset’s book value after its useful life. Usually, it represents the amount that companies can recover by selling it in the market. This value requires companies to estimate the asset’s worth after its useful life. Although it may not be accurate, it is crucial to calculate the depreciable value.
Once companies obtain these figures, they can calculate the depreciable value with the formula below.
Depreciable value = Cost – Salvage value
Example
A company, Red Co., acquires a manufacturing machine. The company pays $10,000 to its supplier. On top of that, it also incurs transportation costs of $3,000 on it. Apart from that, the company pays taxes on it, amounting to $1,000. Therefore, the machine’s cost under IAS 16 principles will be $14,000.
Red Co. estimates it will use the asset for five years, also its useful life. The company estimates the machine to have a salvage value of $2,000 after that period. Therefore, its depreciable value will be as below.
Depreciable value = Cost – Salvage value
Depreciable value = $14,000 – $2,000
Depreciable value = $12,000
Conclusion
Depreciation is a method through which companies spread the costs of a fixed asset over its useful life. Usually, companies can choose between several approaches to calculate the charge. Before that, however, they must measure the asset’s depreciable value. This calculation requires deducting its salvage value from its cost.
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