Depreciating a building that is rising in value
Why a client must still depreciate a building whose market value is rising, how land is treated, and the honest role of residual value in the charge.
By Achekam · · 4 min read · For Accountants & audit firms in South Africa, Nigeria, Kenya
"Why are you depreciating my building? It's worth more than I paid for it." It is one of the objections an owner-managed client raises most often, and on its face it sounds reasonable. Property prices are up, a valuer agrees, and here is the accountant knocking the building's value down every year.
The objection rests on a misunderstanding of what depreciation is for.
Depreciation spreads cost; it does not value
ACCA explains that depreciation is an accrual technique, not a provision for loss of value, so assets that are increasing in value must still be depreciated.
"Accrual technique" is the key phrase. The building is used to run the business every year. Its cost is a cost of earning the income in each of those years, and depreciation spreads that cost across them, much as an annual insurance premium is spread across the months it covers. Whether the market price of the building rises or falls in the meantime does not change the fact that the business is using it up.
Investopedia makes a related point: an asset's carrying value often differs significantly from its market value. The statements are not a valuation report, and a carrying amount is not a price.
Land and buildings: separate the land
The land under the building is a different matter. Investopedia explains that land is not depreciated because it is considered to have an unlimited useful life.
So the price of a property has to be split between land and buildings, and only the building part is depreciated. Common sources for the split:
- the municipal valuation, where it separates land from improvements;
- a valuer's report obtained at purchase;
- the cost of construction, where the client built on land it already owned.
A property carried as one undivided amount and depreciated in full overstates the charge. One carried in full with no depreciation at all understates it. Both are common in small-company files. The building may also have significant parts with different lives, such as the roof, the lifts and the services, which need separate treatment; see depreciating significant parts separately.
Residual value: the honest lever
There is a legitimate way for a strong property market to affect depreciation: the residual value. ACCA explains that IAS 16 requires useful life and residual value estimates to be reviewed at the end of each reporting period, with significant changes accounted for over the remaining useful life as a change in accounting estimate.
Residual value is the estimate of what the building will be worth at the end of its useful life to the client. A well-built building in a strong location may have a high residual value, which leaves less of its cost to be depreciated and so produces a smaller charge.
The discipline is that the residual value must be an estimate supported by evidence and reviewed each year, not a figure chosen to make the charge disappear. A residual value that moves in step with the client's wish for higher profit is a warning sign for any reviewer.
Explaining the charge to a client who expects none
A short explanation that works with most owners:
- "Depreciation is not saying your building lost value. It spreads what you paid over the years you use it."
- "We don't depreciate the land, only the building standing on it."
- "If the building will still be worth a lot when you've finished with it, that goes into the residual value, which reduces the charge."
- "The market value is a real and useful number, for borrowing or for selling, but it is a different number from the one the statements carry."
Most clients accept the point once they see that the charge is about using the building, not about its price. It can help to show the owner the building's carrying amount beside the latest valuation. The gap between them is not an error in the statements; it is the difference between two honest numbers that answer two different questions.
Policy wording and Achekam's depreciation check
The Studio's standard policy wording is based on IFRS for SMEs and labelled for review before issue, and staff can write their own policies. The depreciation policy should say plainly that land is not depreciated, which method and useful lives apply to buildings, and that residual values and useful lives are reviewed each year. Notes take their figures from the mapped trial balance, with facts the trial balance does not hold left as "[to be completed]".
Achekam does not calculate depreciation. It shows the charge the trial balance holds, raises a flag when that charge disagrees with the movement in accumulated depreciation, and lets staff post a year-end adjusting entry, which is reversed with who and why if it later proves wrong.
Be aware of what the flag can and cannot catch. A client that simply stopped depreciating its building because it was "going up" will have posted neither a charge nor any movement in accumulated depreciation, and the two will agree. The preparer has to look for a missing charge directly, by comparing this year's charge on buildings with last year's and with the register. More on how the check works is in depreciation in the statements.
ACCA's article on measuring and depreciating property, plant and equipment explains the initial measurement and depreciation of property, plant and equipment under IAS 16.
A rising property market is good news for the client's net worth. It is not a reason to stop depreciating the building, and the firm that explains the difference calmly, once, usually does not have to explain it again.
General guidance only, not advice on your own circumstances. Tax and payroll rules change: check the current position with the authority or your adviser.
