Depreciable Base

Depreciation spreads the cost of an asset over the periods that benefit from it, but not all of the cost: the part that will come back when the asset is sold or scrapped at the end of its life has not been consumed and should not be charged. The depreciable base is the portion that will be consumed, and the depreciation method decides how it is spread.

Two estimates therefore sit under every depreciation charge before the method is even chosen: what the asset cost, and what it will be worth at the end. Cost is broader than the invoice.

Accounting standards define it as the purchase price, including import duties and non-refundable taxes and net of trade discounts, plus any costs directly attributable to bringing the asset to the location and condition necessary for it to operate as intended. That includes delivery and handling, site preparation, installation and assembly, professional fees such as architects' and engineers' fees, and the cost of testing that the asset works.

For a self-constructed asset it includes materials, labour and, where the asset takes a substantial period to build, borrowing costs during construction. It excludes costs that are not necessary to make the asset work: staff training, initial operating losses while the asset reaches capacity, administration and general overheads, and the costs of relocating or reorganising the business around it, all of which are expensed as incurred.

Salvage value, also called residual value or scrap value, is the estimated amount the business would currently obtain from disposing of the asset at the end of its useful life, less the costs of disposal, assuming the asset were already of the age and condition expected at that date. For many assets it is small enough to ignore: a computer, a piece of office furniture, a machine with no second-hand market.

For others it is large and material: vehicles, aircraft, ships, construction equipment and property all retain substantial value, and ignoring it over-depreciates the asset during its life and produces a gain on disposal that is really the reversal of past over-depreciation. Where the useful life to the business is shorter than the asset's physical life, because the business plans to replace it early, salvage value is what the asset will fetch at the planned replacement date, which can be a large fraction of cost.

Both estimates are reviewed at least annually and revised when expectations change. A revision is applied prospectively: the remaining carrying amount, less the revised salvage value, is spread over the revised remaining life from that point, with no restatement of past periods.

Assets with significant parts that wear out at different rates are depreciated by component, each with its own base and life: an aircraft's airframe, engines and interior; a building's structure, roof and services. Component accounting produces more accurate charges and handles replacements cleanly, since the old component's remaining base is written off when the new one is capitalised.

The base matters beyond the depreciation charge. It determines the carrying amount at every point in the asset's life, and so the gain or loss on disposal, the figures used in return on assets and asset turnover, and the amounts tested for impairment.

For tax, the base may be defined differently, with some costs excluded or included and salvage value ignored, which is one source of deferred tax. And decisions to capitalise or expense borderline costs move amounts between the balance sheet and the income statement, which is why the definition of cost is a standard area of audit attention.