Depreciation is a systematic allocation of the cost of a depreciable asset to expense over its useful life. It is a process of charging the cost of fixed asset to profit & loss account.
Fixed Assets are those assets which are:
• Of long life
• To be used in the business to generate revenue
• Not bought with the main purpose of resale.
Fixed assets are also called “Depreciable Assets”
Accumulated Depreciation is the depreciation that has been charged on a particular asset from the time of purchase of the asset to the present time. This is the amount that has been charged to profit and loss account from the year of purchase to the present year.
Depreciation accumulated over the years is called accumulated depreciation.
Useful Life
• Useful Life or Economic Life is the time period for machine is expected to operate efficiently.
• It is the life for which a machine is estimated to provide more benefit than the cost to run it.
Methods of calculating Depreciation
There are several methods for calculating depreciation. However two are important.
• Straight line method
• Reducing balance method or written down method.
Straight line method
It is based on the principle that each accounting period of the asset's life should bear an equal amount of depreciation.
As a result, the depreciation charge for the asset can be calculated using the following formula:
Annual straight-line depreciation charge = (Cost of the asset - Residual value of the asset )/ N
Where N =Useful economic life of the asset (years)
Residual value is the cost of the asset after the expiry of its useful life.
Illustration
A business purchases a new machine for £110,000 on 1 January 2008. It is estimated that the machine will have a residual value of £10,000 and a useful economic life of five years. The business has an accounting year end of 31 December.
Using the straight line depreciation method, the calculation of the annual depreciation charge is as follows:
Annual straight-line depreciation charge = (Cost of the asset - Residual value of the asset )/ N
Annual straight-line depreciation charge = (110,000 - 10,000 )/ 5= £20,000
In the accounts of the business a depreciation charge of £20,000 will be expensed in the profit and loss account for each of the five years of the asset's useful economic life.
In the annual balance sheet, the machine would be shown at its original cost less the total accumulated depreciation for the asset to date.
Reducing balance method or written down method.
The reducing balance method of depreciation provides a high annual depreciation charge in the early years of an asset's life but the annual depreciation charge reduces progressively as the asset ages.
To achieve this pattern of depreciation, a fixed annual depreciation percentage is applied to the written-down value of the asset. Thus, depreciation is calculated as a percentage of the reducing balance.
Illustration
A business purchases a new machine for £110,000 on 1 January 2008. It is estimated that the machine will have a residual value of £10,000 and a useful economic life of five years. The business has an accounting year end of 31 December.The business decides to calculate annual depreciation at the rate of 40% of the written-down value.
Using the reducing balance method, the calculation of the annual depreciation charge is as follows:
For 31 dec 2008
Original machine cost £110,000
Depreciation in 2008 (40% cost) £44,000
Written down value at 31 December 2008 £66,000
For 31 dec 2009
Depreciation in 2009 (40% of WDV of £66,000 31 december 2008) £26,400
Written down value at 31 December 2009 £39,600
and so on...........
In reducing balance method, a formula is used for calculation the depreciation rate i.e.
Rate = 1 –n√ RV / C
Where:
“RV” = Residual Value
“C” = Cost
“n” = Life of Asset
Calculate the rate if:
Cost = 100,000
Residual Value (RV) = 20,000
Life = 3 years
Rate = 1 –3√ 20,000 / 100,000
Rate = 42%
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