Effective Methods of Depreciation Calculation

1. Depreciation 1

2. Depreciation is the apportioning of the cost of a fixed asset over the life of the asset. Depreciation

3. Wear and tear Erosion and decay Depletion Obsolescence Inadequacy Passage of time Causes of depreciation

4. The two main methods in use are: Straight line method Reducing balance method Methods of calculating depreciation

5. Twoways of calculating this method of depreciation: Straight line method • A fixed percentage is written off the original cost of the asset each year.

6. For example, an asset costs £20,000 and depreciation is written off at 10% on cost each year. Therefore the depreciation will be £2,000 per year for the asset’s useful life of 10 years.

7. 2. Using a formula Annual depreciation charge =Cost – estimated residual value Number of years expected use The residual value is the estimate of the amount the business will get for the asset when they sell it.

8. Example A machine is purchased for £4,600. Its useful life is expected to be four years, after which time it will be replaced. It is expected that it will have a trade in value of £400. RequiredCalculate the annual depreciation charge using the straight line method.

9. Answer Annual depreciation charge = 4,600 – 400 4 = £1,050 per year

10. A fixed percentage is written off the net book valueeach year. Reducing balance method

11. Example Tanya Tarleton purchased a delivery van for £18,000 on 1 January 2005. Depreciation is to be calculated at the rate of 20% per annum using the reducing balance method. Required Calculate the annual depreciation charge in years 2005, 2006 and 2007.

12. £ Cost 18,000 2005 – 20% 3,600 Net book value 14,400 2006 – 20% 2,880 Net book value 11,520 2007 – 20% 2,304 Net book value 9,216 Answer

13. Straight line method: Same amount is charged each year. Lower depreciation percentage required to achieve same residual value. Best used for fixed assets that lose value evenly throughout their life, e.g. office equipment, fixtures and fittings. Comparisons of the straight line and reducing balance methods

14. Reducing balance method: Different amounts charged each year. Best used for fixed assets, which depreciate more in early years and which are not kept for the whole of expected lives, e.g. vehicles. High depreciation early in asset’s life – low repairs and maintenance. Low depreciation later in asset’s life – higher repairs and maintenance.

15. On occasions part year depreciation will need to be calculated. If the asset is purchased partway through the year, for example a motor vehicle is purchased on the 1 July and the financial year-end is 31 December. The asset has been owned for 6 months and therefore only 6/12 of the annual depreciation should be charged for the first year. Calculating part year depreciation

16. Example Sarah Southport has a year ending 31 December. On 1 July 2006 she purchased machinery at a cost of £60,000. Her policy on calculating depreciation is 20% reducing balance method. Calculate the depreciation for the year ending 31 December 2006 and 2007. Depreciation is calculated for each month the asset is owned.

17. Answer £ Cost 60,000 31/12/06 (20% x 6/12) 6,000 Net book value 54,000 31/12/07 – 20% 10,800 Net book value 43,200

18. Take care when reading questions as to whether you need to calculate a full year’s depreciation or part year’s depreciation. Show all your workings. Tips

19. Complete Questions 1-3 on task sheet. Tasks