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 organisations 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 fixed asset 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 the asset.

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.

Upgradeable assets

Upgradeability is a particular feature of some IT assets. In general, organisations use one of three methods, described below. The first two can cause serious distortion to the accounts, and to budgets, if the amounts are significant.

The first option, treating each upgrade as though it were a separate new asset, can cause a 'depreciation peak' in the mid-life of the asset, quite unrelated to its contribution to earning revenue. This tends to happen in particular, as is often the case, an upgrade is acquired before the end of the expected useful life of the base asset.

Secondly, it is possible to depreciate the base asset and subsequent upgrades to the expected end of life of the range. As they may be quite a long period, it can seem attractive in the early years because of the low annual charge.

However, the periods over which successive upgrades can be depreciated are progressively shorter, and the per annum depreciation of the upgraded asset becomes higher and higher.

Thus, this approach also results in a depreciation peak, this time at the end of asset life rather than in the middle.

The third method, reassessing remaining useful economic life after each upgrade, reflects the fact that the effect of an upgrade is to prolong the useful economic life of the base asset. It requires that on acquiring a base asset, the expected useful life of that asset be assessed, ignoring possible upgrades.

On acquiring each upgrade a fresh assessment should be made of the remaining useful life, and the remaining book value depreciated over that period.

This method avoids depreciation peaks and comes closest to representing what is actually happening. It also allows for an indefinite number of upgrades.

Depreciation may be a simple concept, but inappropriate methods, and overestimation of asset life, can seriously distort both profit and loss accounts and budgets.

Attempts to avoid 'loss on disposall can sometimes even have serious operational effects, by (for example) inhibiting the acquisition of possibly much-needed replacement systems.

This article was written by Michael Blackstaff in June 2006. He is the author of the new BCS book Finance for IT Decision Makers (2nd Edition), which includes a chapter on financial aspects of outsourcing co-authored with Hugh Pike.