I am just curious, because even though computers depreciate fast in terms of value, the useful life of them can usually vastly exceed the normal useful life of 3-5 years. In my department for example, we used to replace computers every 3 years but have now changed this to 5 years. Wouldn't it be more effective to depreciate computers using the reducing balance method (more complicated I know but better in my opinion in calculating the true values of computers held as assets)?
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Allocation of cost not value
We are not trying to value the computers. We are trying to allocate the cost over the expected useful life.
Exactly so
Depreciation is a method of spreading the cost over the estimated useful ife of an asset. It is not meant to represent the market value of the asset at any point between acquisition and obsolescence.
Yes,
The depreciation method chosen should reflect how the asset is consumed by the business. If each period benefits equally from the use of the asset and the costs of ongoing maintenance are even, then straight line depreciation is the appropriate method.
Front-loaded methods of depreciation. like reducing balance and SOD, are more appropriate to assets that wear out, such that the maintenance costs increase over time.
Yes and no
Yes, depreciation is simply a method of allocating costs over the lifetime of an asset and NBV is not intended to reflect value.
No, that does not justify using a wholly inappropriate depreciation method. Or at least in my opinion it doesn't.
Take the example of a car: after 3 years, most of these are valued in the real world at something a bit south of 50% of original cost. Using 25% RB gives an NBV after 3 years of 42% of cost; using 25% SL gives a remaining NBV of only 25%. I know which method appears more realistic to me, and not just for cars.
Realistic?
Why do you say it's more realistic?
Because it reflects value? You've explained that NBV is not intended to reflect value.
@ Adam
The purpose isn't to have an NBV that is in line with the value of the car, but to correctly value profits year on year.
Also, if an appropriate depreciation rate under RB is 25%, then the SL "equivalent" wouldn't also be 25%. It would be more along the lines of 20% which wouldn't give you a dissimilar figure anyway.
If all the periods in which the asset is used benefit equally from the use of the asset, then the total costs of ownership (depreciation and maintenance) should be charged evenly against profits.
And for that reason I agree with you that for a motor vehicle that a business intends to retain for a period of many years then reducing balance is probably appropriate, because maintenance costs are likely to increase over its life.
With a modern car being retained for a period of only a few years though, straight line is probably a more appropriate way to value profits.
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Also, if an appropriate depreciation rate under RB is 25%, then the SL "equivalent" wouldn't also be 25%. It would be more along the lines of 20% which wouldn't give you a dissimilar figure anyway.
That is true. I don't disagree with you in principle but how often do you see a 20% dep'n rate for MVs? Off the top of my head, and dwelling at the bottom of the market as I do, I can't think of any accounts I have seen which don't use 25%.
Plus 20% SL still leads to a £nil NBV after 5 years and then a bizarre profit on disposal when sold which has to be explained to the client. That isn't "realistic" IMHO. Peter, I acknowledge your point that NBVs aren't intended to be a reflection of value but, again IMO only, I personally don't see that as a justification for using a depreciation method which doesn't even connect tangentially with real life.
Ido not expect my new Toshiba will last over three years. It is great, but most of its parts are
plastic, So I would be lucky if last two years.
@ Adam
If you expect to sell the asset after five years, then you should estimate the residual value at the outset and only depreciate from original cost to residual value.
I agree that blanket policies are often applied that don't achieve that aim, but that's not a problem with the principle, but the application of it in practice.
Even if done properly, you will get a disparity between depreciated cost and value. The purpose of depreciation is to spread the net cost (historic cost, less residual value) over the life of the asset as a charge against profits.
Revaluation and impairment are the tools you should use to reflect real life.
What is it you are depreciating?
Depreciation should be based on the cost to the business over the asset's economic life. "Cost to the business" is not purchase price, but purchase price less expected residual value.
EDIT - crossed in the ether with Steve's comment :)
@Steve
I do understand all the theory although, as you can probably tell, I don't necessarily always agree with how it is applied and feel that its mindless application often gives a reductio ad absurdum result.
As you acknowledge yourself, moreover, the application of that theory is usually cherry-picked so that only the easy bits are applied. Yes, residuals should be considered but, let's be honest, how often are they? And indeed, how often should they be?
For a very material one-off asset, then yes, definitely. For a run-of-the-mill everyday asset like computers or cars, then no, that's a needless complication. Particularly when a dep'n method exists (ie RB) which effectively allows for residuals by always leaving a balance still to be depreciated.
Define the asset
I'm not arguing with the general discussion at all, but IT equipment always gives me a particular problem. A desktop PC, at least in this business, is like the 25 year old hammer that's had 12 new heads and 8 new handles. Over a period of maybe 4 years, every part of it might have been upgraded, either because bits failed, or for improvement. And old bits of this one will have been redeployed in others. "New" PCs are created from parts of others which could include our own personal computers, or family and clients' discarded systems.
I suppose the theory is that I should record a replacement for a broken item as a Repairs and Renewals expense, and improvements as additions to the asset, but this gets silly! For example, a graphics card from one of my husband's computers could be used to replace a dead graphics card in a client's computer. He might then take another graphics card from a family member's discarded computer in its place! How the blazes can I record any kind of sensible costs for that lot?