Depreciation

How depreciation is calculated under IFRS

• Cost and residual value. The depreciable amount is the asset’s cost less the amount the company expects to get for it at the end of its use (IAS 16).
• Useful life. The company estimates how long it will use the asset, for example 25–40 years for buildings, 5–15 years for machinery and 3–5 years for IT equipment. These estimates are disclosed in the notes and reviewed every year.
• Method. Most Nordic companies use the straight-line method: the same amount every year. Other methods, such as reducing balance or units of production, are allowed if they better reflect how the asset is used up.
• Land and goodwill are not depreciated. Land is assumed to last indefinitely. Goodwill is not amortised under IFRS; instead it is tested for impairment at least once a year (IAS 36).
• Leased assets. Since IFRS 16, most leased assets, such as offices, shops and vehicles, are booked as right-of-use assets and depreciated over the lease term. For retailers this has become a large part of total depreciation.

Depreciation, amortisation and impairment

The line in the income statement often combines three different things:

• Depreciation of property, plant and equipment and right-of-use assets: a planned, recurring cost.
• Amortisation of intangible assets. Amortisation of intangibles acquired in business combinations, such as customer relationships and technology, is often excluded from adjusted earnings, because it reflects past acquisitions rather than the running business.
• Impairment: a one-off write-down when an asset’s recoverable amount falls below its carrying amount, for example when a plant is closed or an acquired business performs worse than expected. Impairments are irregular and are usually treated as items affecting comparability.

When you compare depreciation between years, check the notes to see how much of the line is impairment. A sudden jump is usually an impairment, not a change in the business’s normal capital needs.

How to read depreciation

• Depreciation as a share of revenue shows how capital-intensive the business is. Telecom operators, utilities and forest companies have high ratios; software and service companies have low ones. The table on this page shows the ratio for each company we track.
• Compare with capital expenditure. If a company invests much less than its depreciation year after year, its asset base is shrinking or ageing. If it invests much more, it is growing, or its depreciation will rise later. See capital expenditure.
• It links EBITDA and operating profit. EBITDA minus depreciation and amortisation equals operating profit. The bigger the share of depreciation, the bigger the gap between the two, and the more misleading EBITDA alone can be.
• Watch changes in useful lives. Extending useful lives lowers depreciation and raises profit without any change in the business. Companies disclose such changes in the notes.

Depreciation in the accounts and in taxation

Tax rules set their own depreciation methods and maximum rates, which usually differ from the depreciation in the IFRS financial statements. In Finland, for example, machinery and equipment are depreciated for tax purposes on a reducing-balance basis at a maximum rate set in the Business Income Tax Act, while the IFRS accounts usually use straight-line depreciation over the estimated useful life.

When tax depreciation is faster than accounting depreciation, the company pays less tax today and more later. The difference is recorded as a deferred tax liability in the balance sheet. For investors, this means the cash taxes paid in a year of heavy investment can be well below the tax expense in the income statement.