IB Business and Management 3.5 Depreciation (HL Only)

Learning Objectives Understand the causes of depreciation Understand the impact of depreciation on the profit and loss account and balance sheet Calculate depreciation using the straight line and reducing balance methods Evaluate the strengths and weaknesses of each method

? Recap Balance Sheet What can you tell me about Balance Sheets? 2 minutes…. Brainstorm all you can remember Balance Sheet ?

Task Which section of the Balance Sheet? Fixed Asset Current Asset Current Liability Capital Employed

Which section of the Balance Sheet? A delivery van

Which section of the Balance Sheet? Money invested in the business by the owner

Which section of the Balance Sheet? Shop premises

Which section of the Balance Sheet? Money in the Bank

Which section of the Balance Sheet? A bank loan taken out

Which section of the Balance Sheet? Stocks of goods

Which section of the Balance Sheet? Profits retained in the business

Which section of the Balance Sheet? Creditors

Which section of the Balance Sheet? Cash at premises

What is Depreciation? Depreciation is the reduction of a value of a fixed asset Do all fixed assets depreciate? What causes depreciation?

Depreciation in Practice

Causes of Depreciation Usage (Wear and Tear) Time Obsolescence (due to technology, fashion etc) Examples?

Depreciation and accounts Depreciation has an impact on both the balance sheet and profit and loss account of a business

Depreciation in Accounts Calculation of annual depreciation Reduce value of asset in the balance sheet Include as an expense on the profit and loss account

Depreciation and the Balance Sheet The balance sheet aims to give a true and fair account of the value of a businesses assets As the value of fixed assets depreciates this needs to be reflected in the figure shown

Balance Sheet – Reminder of the IB structure Fixed Assets Less Depreciation = Net Fixed Assets

Depreciation and the Profit and Loss Account Capital expenditure should be seen as advanced payment for the use of an asset over a period of time Although the asset may have been paid for all at once, in its accounts the businesses spreads the cost over a number of years – Why? This avoids excessive costs recorded in the year of purchase

Calculating Depreciation How do accountants decide how much depreciation to include in the P&L account each year? Calculating Depreciation

Calculating annual depreciation There are 2 methods you need to be able to use to calculate annual depreciation: The straight line method The reducing balance method

Before we start…. Some key terms you need to know. Residual Value Initial Cost Annual Depreciation Book Value Useful Life What do you think these terms mean?

Straight Line Method Annual Provision for Depreciation= The Straight line method involves reducing the value of the asset evenly over it’s useful life. The yearly depreciation is calculated by: Annual Provision for Depreciation= 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐶𝑜𝑠𝑡 −𝑅𝑒𝑠𝑖𝑑𝑢𝑎𝑙 𝑉𝑎𝑙𝑢𝑒 𝑈𝑠𝑒𝑓𝑢𝑙 𝐿𝑖𝑓𝑒

Example A firm buys a delivery van for £15,000 in 2011 They plan to keep the van for 3 years They estimate that they will be able to sell the van at the end of the 3 years for £8,400 Calculate the yearly depreciation for the van: £15,000 - £8,400 = £2,200 per year 3 How will this impact on the book value of the van?

Calculating the Book Value Year Initial Value Annual Depreciation New Book Value 1 15,000 2,200 12,800 2 10,600 3 8,400

IB Question Time – 3 mins Have a go at this question: Gemel Ltd ‘Peter examined the figures and pointed out that George had omitted a provision for depreciation of the firm’s fixed assets, which were valued at $200 000 on start-up. He suggested that George worked on the basis of a four-year life for the assets and estimated a scrap value of $40 000.’ Calculate the annual depreciation assuming a straight line method of depreciation is used.(Show all your working). [2 marks]

Mark Scheme: SLD = 𝐻𝑖𝑠𝑡𝑜𝑟𝑖𝑐 𝐶𝑜𝑠𝑡 −𝑆𝑐𝑟𝑎𝑝 𝑉𝑎𝑙𝑢𝑒 𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝐿𝑖𝑓𝑒 = $200,000−$40,000 4 = $40 000 p.a. [2 marks] The calculation is accurate and the working shown, although the formula may not be stated. [1 mark] The calculation is accurate but no working shown or inaccurate with appropriate working.

Reducing balance method The reducing balance method involves reducing the value of the asset by a certain percentage each year

Example A firm buys a delivery van for £15,000 in 2011 They plan to keep the van for 3 years They will reduce the value of the asset in the balance sheet by 17.5% each year How will this impact on the book value of the van?

Book value of the asset Year Initial Value Annual Depreciation New Book Value 1 15,000 2,625 12,375 2 2,166 10,209 3 1,787 8,422

IB Question Time – 5 mins Have a go at this question: Neat Organization Neat Organization is a leading provider of resort-based budget holidays in Spain for price conscious consumers. As part of its growth strategy, Neat Organization intends to purchase some new coaches. The initial cost of the coaches is $1 000 000. After 7 years (the predicted useful life of the coaches), the management hopes that they will have enough residual value that can then be used towards purchasing a new fleet. Calculate the depreciation at 20 % using the reducing balance method for the first 7 years of the coaches (Show all your working). [3 marks]

Year end Workings Depreciation Value of coaches – 1 000 000 1   – 1 000 000 1 20 % × 1 000 000 200 000 800 000 2 20 % × 800 000 160 000 640 000 3 20 % × 640 000 128 000 512 000 4 20 % × 512 000 102 400 409 600 5 20 % × 409 600 81 920 327 680 6 20 % × 327 680 65 536 262 144 7 20 % × 262 144 52 428.80 209 715.20 [1 to 2 marks] if the correct procedure has been followed but there is an error(s) in the calculation(s). Deduct [1 mark] per error, but do not penalize for errors that have been carried forward. So if two errors have been made and some workings are shown the mark awarded will be [2 marks]. [3 marks] for the correct final value ($209 715.20) and no errors. Some of the workings are shown and some of the calculations are well presented.

Evaluating Depreciation methods

What difference will this make to the P&L Account and the Balance Sheet in each different year?

Key Questions: Which method is more simple to calculate Which method is more realistic? What difficulties could there be if using the straight line method? Which method will lead to a higher value for fixed assets in the first years after the purchase? Which method will lead to higher profit figures in the first years after the purchase?

Homework Complete exercises c-e from sheet Optional Extension Question: A firm has bought an asset for £200,000. They estimate it will have a useful life of 3 years after which time it will have a residual value of approximately £100,000. If the reducing balance method is used what % annual depreciation should they use? Due Date: Monday October 10th