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Depreciation (SL & HL) Content

Depreciation (SL & HL) Content . P220-222 ( Stimpson & Smith, 2012, Business & Management for the IB Diploma Program. The Straight Line Method ( Vs ) The Reducing Balancing Method of Depreciation . Straight Line Depreciation

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Depreciation (SL & HL) Content

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  1. Depreciation (SL & HL) Content P220-222 (Stimpson & Smith, 2012, Business & Management for the IB Diploma Program

  2. The Straight Line Method (Vs)The Reducing Balancing Method of Depreciation Straight Line Depreciation A constant amount of depreciation is subtracted from the value of the asset each year. Reducing Balancing Method Calculates depreciation by subtracting a fixed percentage from the previous year’s net book value. Net Book Value The current balance sheet value of a non current asset = original cost – accumulated depreciation.

  3. Straight Line Method of Depreciation To calculate the annual amount of depreciation the following information will be needed: • The original or historical cost of the asset. • The expected useful life of the asset. • An estimation of the value of the asset at the end of its useful life – this is known as the residual value of the asset.

  4. Straight Line Method Formula The formula: Annual Depreciation Charge = Original Cost of Asset – Residual Value Expected useful life of the assets

  5. Straight Line Method - Advantages • It is easy to calculate and understand. • It is widely used by limited companies. • Look in the annual account of many limited companies and you will see they are using the straight line method.

  6. Straight Line Method-Disadvantages • It requires estimates to be made regarding both life expectancy and residual value. Mistakes at this stage will lead to inaccurate depreciation charges being calculated. • Certain assets – like cars, trucks and computers tend to depreciate more quickly in the 1st & 2nd years than in subsequent years. This is not reflected in the straight line method of calculation – all annual depreciation charges are the same. • The reducingbalance method of depreciation depreciates assets by a greater amount in the first few years of life than in later years. • There is no recognition of very rapid pace at which advances in modern technology tend to make existing assets redundant.

  7. Practical ExampleStraight Line Method • A company purchases a new machine for $9000 • It has as residual value of $600. • It has an effective life of 4 years. $9000 - $600 = 8400 / 4 = $2100

  8. Practical ExampleStraight Line Method

  9. Reducing Balance Method of Depreciation • This method of calculating depreciation solves some of the problems identified by the straight-line method. • It leads to higher levels of depreciation in the early years of an assets life, but lower depreciation as the asset ages. • Unlike the straight line method, you will be given a % number which is used to depreciate the asset every year, from the reduced balance. • There is a formula for this calculation, but it is easier to understand the process with a practical example.

  10. Practical Example Reducing Balance Method • A delivery company purchases a van for $16,000. • The depreciation rate is 30%. • The estimated useful life of the van is 4 year.

  11. Practical Example Reducing Balance Method At the end of 4 years, the van is only worth $3842. This is the residual value.

  12. Reducing Balance MethodAdvantages • It more accurate than the straight-line method especially where assets lose value in their early years. • Many assets are more efficient and profitable when new, so it is more logical to “match” a higher amount of cost to the asset against the higher profit.

  13. Reducing Balance MethodDisadvantages • By calculating a “precise” rate of inflation its suggests a level of accuracy for the process of depreciation which is unjustified – the residual value and expected life span are always estimates and this distracts from the achievement of complete accuracy.

  14. Reducing Balance Method - Exercises • A company purchases a large item of machinery for $105,000. • It has a useful life for 4 years. • The depreciation rate is 25% • Calculate the annual depreciation amount and the net book value for each year.

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