Depreciation 1

© Hodder Education 2008 Depreciation Depreciation is the apportioning of the cost of a fixed asset over the life of the asset.

© Hodder Education 2008 Causes of depreciation  Wear and tear  Erosion and decay  Depletion  Obsolescence  Inadequacy  Passage of time

© Hodder Education 2008 Methods of calculating depreciation The two main methods in use are: Straight line method Reducing balance method

© Hodder Education 2008 Straight line method Two ways of calculating this method of depreciation: 1. 1.A fixed percentage is written off the original cost of the asset each year.

© Hodder Education 2008 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.

© Hodder Education 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.

© Hodder Education 2008 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. Required Calculate the annual depreciation charge using the straight line method.

© Hodder Education 2008 Answer Annual depreciation charge = 4,600 – = £1,050 per year

© Hodder Education 2008 Reducing balance method A fixed percentage is written off the net book value each year.

© Hodder Education 2008 Example Tanya Tarleton purchased a delivery van for £18,000 on 1 January 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.

© Hodder Education 2008 Answer £ Cost18, – 20%3,600 Net book value14, – 20%2,880 Net book value11, – 20%2,304 Net book value9,216

© Hodder Education 2008 Comparisons of the straight line and reducing balance methods 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.

© Hodder Education 2008 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.

© Hodder Education 2008 Calculating part year depreciation 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.

© Hodder Education 2008 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 Depreciation is calculated for each month the asset is owned.

© Hodder Education 2008 Answer £ Cost60,000 31/12/06 (20% x 6/12)6,000 Net book value54,000 31/12/07 – 20%10,800 Net book value43,200

© Hodder Education 2008 Tips  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.

© Hodder Education 2008 Tasks  Complete Questions 1-3 on task sheet.