DEPRECIATION
Depreciation
is an estimate in amount for the wear and tear of a non-current asset used in a
business for its day-to-day operations. It is a part of the original cost of
such asset that is consumed during its period of use by the business and it is
represented in the statement of profit or loss as an expenditure, calculated as
a fraction of the total cost of the asset.
The
two most common methods of calculating depreciation are;
·
Straight line method
·
Reducing balance method
With
straight line method of depreciation, the total value of the asset less any
residual value (if any) is written off evenly over the estimated life of the
asset.
Annual
depreciation charge = Cost –
Estimated residual value
Useful
economic life of the asset
With
reducing balance method of depreciation, a fixed percentage is charged on the
cost of the asset in the first year and subsequent years, the same fixed
percentage is charged on the current net book value of the asset.
Annual
depreciation charge in Year 1 = Cost x fixed %
Annual
depreciation charge in Year 2 and subsequent years = Net Book Value x fixed %
Exercise:
An
equipment has been purchased by a business at the cost of £60,000 and it is to
be depreciated at 25% using reducing balance and straight line methods of
depreciation.
Calculate
the annual depreciation charge for the non-current asset for the first two
years.
Answer:
Reducing balance depreciation
Straight line depreciation
Year 1
25% x £60,000= £15,000
25% x £60,000= £15,000
NBV= £60,000-£15,000= £45,000
NBV= £60,000-£15,000= £45,000
Year 2
25% x £45,000= £11,250
25% x £60,000= £15,000
NBV= £45,000-£11,250= £33,750
NBV= £45,000-£15,000= £30,000
So you will see that the depreciation value will start to reduce
where the reducing balance method is used but the depreciation value will
remain the same across 4 years where the straight line method of depreciation
is used.
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