Depreciation Methods (DP IB Business Management)

Understanding Depreciation

• Depreciation is an accounting technique which recognises that the value of fixed (non-current) assets falls over time

  • It reflects wear and tear, the reduction in an asset's value as it ages or obsolescence

• Two common methods of calculating depreciation include

  • Straight line depreciation

  • Units of production depreciation

• Whichever method a business selects, the goal is to allocate the historic cost of the asset in a way that reflects its reduction in value over time
   

Reasons for Calculating Depreciation

Straight Line Method

• The straight line method reduces the value of an asset by the same value each year of its useful life

• Three key variables are required to calculate the annual rate of depreciation of an asset

  • Life expectancy

    • The number of years it is expected to be used before it will need to be replaced

  • Residual value

    • The scrap value of the asset at the end of its useful life

  • Historic cost

    • The initial cost of purchasing the asset
      

• The annual rate of depreciation is calculated using the following formula

• Once the annual rate of depreciation has been calculated, until the end of its life expectancy

  • It is recorded each year as an expense in the income statement

  • The value of the asset is reduced each year by this amount in the balance sheet and is recorded as its book value 

Strengths and weaknesses of the straight line method

• The main benefit of the straight line depreciation over other methods is that it is simple to calculate 

• In many countries it is preferred for tax purposes as it allows for a consistent deduction of depreciation expenses over the asset's useful life

The Main Strengths and Weaknesses of Using Straight Line Depreciation 

Units of Production Method

• The units of production method depreciates an asset based on its usage or production output during an accounting period (usually a year)

  • It is commonly used for assets that wear out based on the number of units produced or hours of operation rather than the passage of time

  • Vehicles commonly lose value as their mileage increases

  • Machinery wears out as it is used in production 

• The units of production calculation involves two steps

Step 1: Calculate the depreciation per unit

Step 2: Calculate the depreciation per time period (year)

• Once the depreciation total has been calculated

  • It is recorded as an expense in the income statement

  • The value of the asset is reduced by this amount in the balance sheet and is recorded as its book value 

Strengths and weaknesses of the units of production method

• This method is more complicated to calculate than the straight line method

• It is more likely to reflect the true running costs of non-current assets such as machinery

The Main Strengths and Weaknesses of Units of Production Depreciation

When to use each Depreciation Method

• The method chosen to depreciate a fixed asset depends on a range of factors, such as

  • Whether the asset is likely to become obsolete

  • Whether the asset is directly used in production

  • Whether its value is closely linked to the amount it is used

Appropriate Situations for each Depreciation Method