Depreciation Methods (DP IB Business Management)
Revision Note
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
Accurately calculate the businesses value | Plan effectively for the replacement of assets | Realistically reflect the performance of assets in financial statements |
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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
Worked Example
Luftig Tours sells hot air balloon flights in the Salzburg area of Austria. The company recently paid €280,000 for a new balloon. Its life expectancy is anticipated to be 7 years. Its residual value is forecast to be €52,500
Calculate the annual rate of depreciation of the new hot air balloon
(2 marks)
Step 1: Deduct the residual value from the historic cost
(1)
Step 2: Divide the result by the life expectancy
(1)
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
Worked Example
Luftig Tours sells hot air balloon flights in the Salzburg area of Austria. The company recently paid €280,000 for a new balloon. Its life expectancy is anticipated to be 7 years. Its residual value is forecast to be €52,500
(a) Calculate the book value to be recorded in the balance sheet for each of the hot air balloon's years of useful life
(4 marks)
(b) Calculate the accumulated depreciation for each year of the the hot air balloon's useful life
(2 marks)
Step 1: Create a table with the following headers
Year | Depreciation | Book Value | Accumulated Depreciation |
0 |
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1 |
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2 |
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3 |
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4 |
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5 |
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6 |
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7 |
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Step 2: Complete Year 0 with the historic cost
Year | Depreciation | Book Value | Accumulated Depreciation |
0 | 0 | €280,000 |
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Step 3: Calculate Year 1 by deducting the annual rate of depreciation
(2)
Step 4: Record these values in the table
Year | Depreciation | Book Value | Accumulated Depreciation |
0 | 0 | €280,000 |
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1 | €32,500 | €247,500 |
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Step 5: Calculate Years 2 to 7 in the same way
Year | Depreciation | Book Value | Accumulated Depreciation |
0 | 0 | €280,000 |
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1 | €32,500 | €247,500 |
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2 | €32,500 | €215,000 |
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3 | €32,500 | €182,500 |
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4 | €32,500 | €150,000 |
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5 | €32,500 | €117,500 |
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6 | €32,500 | €85,000 |
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7 | €32,500 | €52,500 |
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(2)
Step 6: Calculate accumulated depreciation by adding the annual rate of depreciation each year
Year | Depreciation | Book Value | Accumulated Depreciation |
0 | 0 | €280,000 | 0 |
1 | €32,500 | €247,500 | €32,500 |
2 | €32,500 | €215,000 | + €32,500 = €65,000 |
3 | €32,500 | €182,500 | + €32,500 = €97,500 |
4 | €32,500 | €150,000 | + €32,500 = €130,000 |
5 | €32,500 | €117,500 | + €32,500 = €162,500 |
6 | €32,500 | €85,000 | + €32,500 = €195,000 |
7 | €32,500 | €52,500 | + €32,500 = €227,500 |
(2)
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
Strengths | Weaknesses |
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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)
Worked Example
Emilio's Pizzeria purchased a new pizza oven for $22,600
It expects the pizza oven to last for 12,000 hours before it needs to be replaced
It will be sold for scrap for $4,000 after 4 years
(a) Calculate the depreciation expense if Emilio's Pizzeria uses the pizza oven for 2,900 hours in the first year
(3 marks)
Step 1: Calculate the depreciation per unit
(2)
Step 2: Calculate the depreciation for the time period
(1)
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
Strengths | Weaknesses |
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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
Straight Line Method | Units of Production Method |
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Examiner Tip
Some assets appreciate over time
Increasing land and property values should also be recorded in the final accounts
Usually recorded as extraordinary income in the profit & loss account
Higher non-current (long term) asset value is recorded in the balance sheet
Businesses should take a cautious approach in appreciating the value of these assets
It may be deemed fraudulent to misrepresent their value in final accounts - especially if this value is used as leverage to obtain finance
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