Depreciation, revaluation and derecognition

Once an item of property, plant and equipment is recognized at cost, the entity chooses how to carry it afterwards and how to spread its cost over the periods that benefit. IAS 16 offers two measurement models: the cost model (cost less accumulated depreciation and impairment) and the revaluation model (fair value at the revaluation date less subsequent depreciation and impairment). ASPE allows only the cost model. This lesson covers depreciation methods and estimates, component depreciation, changes in estimates, the revaluation model with its surplus in other comprehensive income, depletion of natural resources, and derecognition when assets are sold, retired, destroyed or classified as held for sale. Lesson 11 covers impairment.

Depreciation concepts

Depreciation is the systematic allocation of the depreciable amount of an asset over its useful life. It is an allocation of cost, not a valuation: a building may rise in market value while it is being depreciated. The depreciable amount is cost (or revalued amount) less residual value, the estimated amount the entity would obtain today from disposal if the asset were already of the age and condition expected at the end of its useful life. Useful life is the period over which the asset is expected to be available for use by the entity, or the number of production units expected; it reflects expected usage, physical wear, technical or commercial obsolescence and legal limits, and may be shorter than the asset's economic life if the entity disposes of assets early. Land usually has an unlimited life and is not depreciated; land improvements such as paving and fences are.

Depreciation begins when the asset is available for use, that is, in the location and condition necessary for it to operate as management intends, even if it is not yet used, and ceases at the earlier of derecognition and classification as held for sale. IAS 16 requires residual value, useful life and depreciation method to be reviewed at least at each financial year end; ASPE requires review when events or circumstances indicate a change. Changes are changes in accounting estimates, applied prospectively.

Depreciation methods

The method should reflect the pattern in which the asset's future economic benefits are expected to be consumed. The straight-line method allocates an equal amount each period: (cost − residual value) ÷ useful life. Diminishing-balance methods apply a constant rate to the declining carrying amount, giving higher charges early; double-declining balance uses twice the straight-line rate and ignores residual value in the calculation, but stops when the carrying amount reaches residual value. The units-of-production method allocates cost per unit of output or usage, suited to assets whose wear depends on use, such as vans (kilometres) or machines (hours). A revenue-based method (depreciation based on revenue generated) is presumed inappropriate under IAS 16 because revenue reflects factors other than consumption, such as prices and inflation. Whatever method is chosen is applied consistently unless the expected pattern of consumption changes.

# Depreciation schedules for a service van (illustrative)
cost, residual, life = 72_000, 8_000, 5
km_total = 250_000
km_by_year = [60_000, 55_000, 50_000, 45_000, 40_000]

sl = [(cost - residual) / life] * life

ddb, carrying, rate = [], cost, 2 / life
for y in range(life):
    charge = min(carrying * rate, carrying - residual)
    if y == life - 1:
        charge = carrying - residual         # bring to residual in the final year
    ddb.append(charge); carrying -= charge

per_km = (cost - residual) / km_total
uop = [km * per_km for km in km_by_year]

print(f"{'Year':<5}{'Straight-line':>15}{'Double-declining':>18}{'Units of production':>21}")
for y in range(life):
    print(f"{y + 1:<5}{sl[y]:>15,.0f}{ddb[y]:>18,.0f}{uop[y]:>21,.0f}")
print(f"{'Total':<5}{sum(sl):>15,.0f}{sum(ddb):>18,.0f}{sum(uop):>21,.0f}")

Year   Straight-line  Double-declining  Units of production
1             12,800            28,800               15,360
2             12,800            17,280               14,080
3             12,800            10,368               12,800
4             12,800             6,221               11,520
5             12,800             1,331               10,240
Total         64,000            64,000               64,000

Every method depreciates the same $64,000 over the van's life; they differ only in timing. Double-declining balance charges $28,800 in year 1, more than twice the straight-line $12,800, and very little in the final years, when the carrying amount is already close to residual value. Units of production follows the kilometres driven. Which method is right depends on how the van's benefits are actually consumed: if wear depends on distance, units of production is the most faithful.

Partial periods and changes in estimates

Assets bought or sold during the year are depreciated for the fraction of the year they were available. Some companies simplify by policy, taking a half-year in the year of acquisition and disposal, or a full month for assets acquired in the first half of a month. Canadian tax depreciation (capital cost allowance) uses prescribed classes, declining-balance rates and a half-year rule, adjusted in recent years by accelerated investment incentives and immediate expensing for some classes; book depreciation follows IAS 16 or ASPE, and the difference creates deferred tax (ACCT-212). When an estimate changes, the remaining carrying amount (less the new residual value) is depreciated over the revised remaining life; past depreciation is not restated.

The revaluation model

Under IAS 16, an entity may choose the revaluation model for an entire class of PP&E (for example, all land and buildings), provided fair value can be measured reliably. Revaluations must be made regularly enough that the carrying amount does not differ materially from fair value; volatile items may need annual revaluation, others every three to five years. When an asset is revalued, accumulated depreciation is either eliminated against the gross carrying amount, which is then restated to the revalued amount (the elimination method, most common), or restated proportionately.

A revaluation increase is recognized in other comprehensive income and accumulated in equity as a revaluation surplus, except to the extent it reverses a previous revaluation decrease of the same asset recognized in profit or loss, in which case that part is recognized in profit or loss. A revaluation decrease is recognized in profit or loss, except to the extent there is a revaluation surplus for the same asset, in which case it first reduces the surplus through OCI. The revaluation surplus is never recycled to profit or loss. It may be transferred directly to retained earnings as the asset is used (the difference between depreciation on the revalued amount and on original cost) or when the asset is derecognized.

# Revaluation model with the elimination method (IFRS, illustrative)
cost, life_years = 5_000_000, 25           # head-office building, no residual value
years_used = 5
acc_dep = cost / life_years * years_used
carrying = cost - acc_dep
fair_value = 5_400_000
surplus = fair_value - carrying
print(f"Carrying amount before revaluation {carrying:,.0f}; fair value {fair_value:,}")
print(f"Eliminate accumulated depreciation {acc_dep:,.0f}; revaluation surplus (OCI) {surplus:,.0f}")
new_dep = fair_value / (life_years - years_used)
old_dep = cost / life_years
print(f"Depreciation after revaluation {new_dep:,.0f} vs on cost {old_dep:,.0f}")
print(f"Annual transfer from surplus to retained earnings: {new_dep - old_dep:,.0f}")
# Two years later fair value drops
carrying2 = fair_value - 2 * new_dep
remaining_surplus = surplus - 2 * (new_dep - old_dep)
fv2 = 4_300_000
drop = carrying2 - fv2
to_oci = min(drop, remaining_surplus)
print(f"Later decrease {drop:,.0f}: {to_oci:,.0f} against surplus in OCI, {drop - to_oci:,.0f} in profit or loss")

Carrying amount before revaluation 4,000,000; fair value 5,400,000
Eliminate accumulated depreciation 1,000,000; revaluation surplus (OCI) 1,400,000
Depreciation after revaluation 270,000 vs on cost 200,000
Annual transfer from surplus to retained earnings: 70,000
Later decrease 560,000: 560,000 against surplus in OCI, 0 in profit or loss

An IFRS reporter revaluing Northlake's head-office building after five years eliminates $1,000,000 of accumulated depreciation and credits a $1,400,000 revaluation surplus to OCI. Depreciation rises from $200,000 to $270,000 a year, and $70,000 a year may be transferred from the surplus to retained earnings. Two years later, when fair value falls to $4,300,000, the carrying amount is $4,860,000, so the decrease is $560,000. The remaining surplus is still $1,260,000 after two annual transfers, so the whole decrease is charged against the surplus through OCI and none of it reaches profit or loss, as the program confirms. Revaluation makes the balance sheet more current at the cost of more volatility, more estimation and lower reported profit through higher depreciation.

Depletion of natural resources

Natural resources such as mineral deposits, oil and gas reserves and timber are depleted, usually by the units-of-production method: depletion per unit = (cost − residual value) ÷ estimated recoverable units. Cost includes acquisition, exploration and evaluation costs that are capitalized under the entity's policy, development costs and estimated restoration obligations. IFRS 6 permits entities to continue their existing policies for exploration and evaluation costs within limits, and Canadian mining and energy companies commonly capitalize them. Because reserve estimates change, depletion rates are revised prospectively. Depletion is first charged to inventory (the extracted resource) and becomes cost of sales when sold.

Derecognition

An item of PP&E is derecognized on disposal or when no future economic benefits are expected from its use or disposal. The gain or loss is the difference between the net disposal proceeds and the carrying amount, recognized in profit or loss when the item is derecognized; gains are not classified as revenue. Depreciation is recorded up to the date of disposal before the gain or loss is computed. Assets retired from use but not yet disposed of continue to be depreciated (or are reclassified as held for sale if the criteria are met).

When an asset is destroyed or lost and insurance compensation is receivable, the derecognition of the asset and the recognition of the compensation are separate events: the asset is written off (a loss), and compensation is recognized in profit or loss when it becomes receivable (virtually certain under IFRS, or probable under the US gain contingency and loss recovery guidance, with gains in excess of losses deferred until realized). Replacement assets are recorded at their own cost.

Under IFRS 5, a non-current asset is classified as held for sale when its carrying amount will be recovered principally through sale rather than continuing use: it must be available for immediate sale in its present condition, and the sale must be highly probable, with management committed to a plan, an active programme to find a buyer, a reasonable price and completion expected within one year. Held-for-sale assets are measured at the lower of carrying amount and fair value less costs to sell, presented separately and no longer depreciated. ASPE Section 3475 has similar criteria.