Component depreciation is a procedure in which the cost of an large item of property, plant and equipment is allocated to different components of the asset and each component is depreciated separately.
IAS 16 Property, Plant and Equipment is the IFRS accounting standard that deals with fixed assets and depreciation. It requires that each significant component of an item of property, plant and equipment (also referred to as tangible fixed assets) must be depreciated separately. Because different components of a very large asset may have different useful lives and different salvage values, applying a composite rate of depreciation to the whole asset might not correctly reflect the periodic allocation of the asset’s cost to different periods. Hence, it is appropriate to break down the asset cost to different components as far as practical and treat each component as a sub-asset with its own depreciation estimates.
Component depreciation is different from unit depreciation which is a procedure that calculates depreciation by applying a single rate to each tangible fixed asset. It also differs from group depreciation (or composite depreciation) which involves applying a weighted-average rate of depreciation to a class of similar (or dissimilar) fixed assets.
One advantage of the component depreciation is that it is the most accurate. Further, treating each component as a sub-asset allows precise accounting if the component is replaced before the ‘main’ asset is retired. One potential drawback is that significant calculations are needed both at the time of acquisition of an asset (in allocating the cost to different components) and at the end of each reporting period. However, due to availability of powerful accounting and ERP software, applying component depreciation was never easier.
Alwataki Air operates a fleet of 10 aircrafts, the most recent of which is Boeing 777 acquired 3 years back for $300 million (including $70 for the two engines). Each aircraft is a different variant which was acquired over a period of time since the company’s inception. The engines have a useful life of 20 years and the overall aircraft has a useful life of 30 years. Assume the engine’s residual value is 10% and other component’s composite residual value is 15%. Calculate annual depreciation under unit depreciation and component depreciation approaches.
Because each aircraft is different and because each was acquired at different times, each must be individually depreciated. In fact, because different components such as engines, landing gear, software, cabin fittings, etc. have different characteristics, say useful lives and salvage values, hence each should be depreciated separately. In this particular case, we depreciate engines separately and club all other components together.
The following table shows the calculation:
|Component||Cost||Residual Value||Depreciable Amount||Useful Life||Depreciation Expense|
If instead of depreciation each significant component separately, we lump all the components together and apply an average rate of depreciation to the total cost of the aircraft, we won’t exactly match revenues with expenses.