How to Calculate Depreciation

What Is Depreciation and Why Does It Matter?

Every business buys assets that last more than a year — equipment, vehicles, computers, furniture. But these assets don't last forever. They wear out, become outdated, or lose value over time. Depreciation is how accounting spreads the cost of that asset across the years you use it, rather than hitting your profits all at once in the year you bought it.

If you buy a delivery truck for SAR 200,000, it would be misleading to show a SAR 200,000 expense in year one and zero in the following years. Depreciation fixes this by allocating a portion of the cost to each year the truck is in service.

Under IAS 16 — Property, Plant and Equipment, depreciation is mandatory for all tangible assets with a finite useful life. Land is the exception — it isn't depreciated because it doesn't wear out.

The Three Key Inputs You Need Before Calculating

Before choosing a method, you need three numbers:

• Cost: what you paid for the asset, including purchase price, delivery, installation, and any costs directly attributable to getting it ready for use (IAS 16.16)
• Residual value (salvage value): what you expect the asset to be worth when you're done with it
• Useful life: how many years (or units of output) you expect to use the asset

The depreciable amount is simply: Cost − Residual Value. This is the total amount that gets spread across the useful life.

Method 1: Straight-Line Depreciation

The most common method. You divide the depreciable amount equally across each year.

Formula: Annual Depreciation = (Cost − Residual Value) / Useful Life

Worked Example: Al-Rajhi Equipment Co. purchases machinery for SAR 150,000. Residual value is SAR 10,000. Useful life is 7 years.

Annual Depreciation = (150,000 − 10,000) / 7 = SAR 20,000 per year

When to use it: When the asset delivers roughly equal benefit each year. Office furniture, buildings, most equipment.

Method 2: Declining Balance (Reducing Balance)

This method front-loads the depreciation — higher charges in early years, lower charges later. It's based on a fixed percentage applied to the carrying amount (not the original cost), so the charge naturally decreases each year.

Formula: Annual Depreciation = Carrying Amount × Depreciation Rate

A common approach is the double-declining balance: Rate = (1 / Useful Life) × 2

Worked Example: Noor Trading buys a vehicle for SAR 120,000. Residual value SAR 15,000. Useful life 5 years. Rate = (1/5) × 2 = 40%.

Notice year 5: you only depreciate down to the residual value, not below it.

When to use it: Assets that lose most of their value early — vehicles, technology, computers.

Method 3: Units of Production

Instead of time, this method bases depreciation on actual usage. Perfect for assets where wear depends on how much you use them, not how long you own them.

Formula: Depreciation per Unit = (Cost − Residual Value) / Total Expected Units

Worked Example: A printing company buys a machine for SAR 300,000, residual SAR 30,000, expected to produce 500,000 units. In year 1 it produces 120,000 units.

Depreciation per unit = (300,000 − 30,000) / 500,000 = SAR 0.54 per unit Year 1 depreciation = 120,000 × 0.54 = SAR 64,800

When to use it: Manufacturing equipment, delivery vehicles (based on kilometers), any asset where output varies significantly year to year.

How to Choose the Right Method Under IFRS

IAS 16 says the depreciation method should reflect the pattern in which the asset's future economic benefits are expected to be consumed. In practice:

• Asset benefits you equally each year → straight-line
• Asset is most productive early on → declining balance
• Asset output varies by period → units of production

One critical rule: IFRS prohibits revenue-based depreciation methods. You cannot depreciate an asset based on the revenue it generates, because revenue reflects market factors beyond the asset's consumption.

You must also review the method, useful life, and residual value at least once per year (IAS 16.61). If circumstances change — say the asset lasts longer than expected — you adjust prospectively. No restatement of prior years.

Common Mistakes When Calculating Depreciation

• Forgetting to subtract residual value: The depreciable amount is Cost minus Residual Value, not the full cost
• Depreciating below residual value: Once the carrying amount equals the residual value, stop depreciating
• Using the wrong base for declining balance: Apply the rate to the carrying amount, not the original cost
• Not reviewing estimates annually: IFRS requires annual review of useful life, residual value, and method
• Depreciating land: Land has an indefinite useful life and is never depreciated — separate it from the building cost
• Ignoring component depreciation: If an asset has parts with different useful lives (e.g., an aircraft engine vs. fuselage), each component is depreciated separately under IAS 16.43

Put It Into Practice

You've learned the three main depreciation methods and when to use each one. The best way to solidify this is to calculate some yourself.

On Accountery, you can practice depreciation calculations in worksheet exercises — complete depreciation schedules, calculate carrying amounts, and handle method changes. It's the same work you'll do in the real world, with instant feedback on every answer.