3.5 - Methods of Depreciation
The concept and importance of depreciation
Depreciation refers to the gradual decline in the value of a fixed asset over time, primarily due to usage and the emergence of newer technologies. It is recorded as an expense in the profit and loss account, even though it does not involve an actual cash outflow from the business.
Key aspects of depreciation
- Non-cash expense - Depreciation reduces the reported value of fixed assets on the balance sheet without affecting the business's cash reserves.
- Impact on profits - If depreciation is not accounted for, profits are overstated, which can mislead stakeholders until the asset needs replacement.
- Stakeholder relevance - Accurate depreciation figures help managers, shareholders, lenders, government bodies, and potential investors assess the true worth of the business.
Residual value in depreciation
Residual value, also known as scrap value, is the estimated amount an asset will be worth at the end of its useful life when it is replaced. Forecasting this value is challenging, and it can sometimes drop to zero if the asset becomes obsolete.
Causes of fixed asset depreciation
Fixed assets lose value over time due to several factors:
- Wear and tear - Continuous use leads to physical deterioration, reducing the asset's efficiency and market value.
- Obsolescence - The introduction of newer models or advanced technologies can make existing assets outdated, potentially rendering them worthless.
The straight line method of calculating depreciation
The straight line method spreads the depreciation of a fixed asset evenly over its useful life, deducting the same amount each year.
Where:
- Purchase cost = Initial amount paid for the asset (£)
- Residual value = Estimated value at the end of its life (£)
- Useful lifespan = Expected number of years the asset will be in use
Worked example - Calculating depreciation using the straight line method
A business buys a machine for £18,000 with an expected useful life of 6 years and a residual value of £2,400. Calculate the annual depreciation expense.
Step 1: Identify the values
- Purchase cost = £18,000
- Residual value = £2,400
- Useful lifespan = 6 years
Step 2: Apply the formula
Step 3: Calculate the annual depreciation
The reducing balance method of calculating depreciation
The reducing balance method, also known as the declining balance method, applies a fixed percentage rate to the asset's net book value each year, resulting in higher depreciation charges in the earlier years of the asset's life.
Where:
- Net book value = Current value of the asset after previous depreciation (£)
- Depreciation rate = Fixed percentage applied annually (%)
This approach can also lead to lower tax liabilities in the initial years compared to the straight line method, although the reported net asset value will be lower.
Book value versus market value
Book value is the asset's value as shown on the balance sheet after depreciation, while market value is the actual amount it could fetch if sold.
Worked example - Calculating depreciation using the reducing balance method
A company purchases equipment for £30,000 and applies a depreciation rate of 20% per year using the reducing balance method. Calculate the depreciation for the first two years and the net book value at the end of year 2.
Step 1: Identify the values
- Initial cost (net book value at start) = £30,000
- Depreciation rate = 20%
Step 2: Calculate year 1 depreciation
Net book value at end of year 1 = £30,000 - £6,000 = £24,000
Step 3: Calculate year 2 depreciation
Net book value at end of year 2 = £24,000 - £4,800 = £19,200
Advantages, disadvantages and ethical considerations in depreciation
Choosing between depreciation methods involves weighing their benefits and drawbacks.
Evaluation of the straight line method
- Advantages - Simple to calculate and apply consistently each year.
- Disadvantages - May be misleading as most assets lose more value in their early years.
Evaluation of the reducing balance method
- Advantages - Provides a more realistic estimate of an asset's market value, with higher depreciation in initial years.
- Disadvantages - More complex and time-consuming to compute.
Ethical considerations in depreciation reporting
Ethics and organisational culture influence how depreciation is reported in final accounts.