Study Notes: Business Finance & Accounting

Depreciation of fixed assets

Introduction

In our introduction to accounting for fixed assets, we described how businesses need to account for the consumption of fixed assets over time in a way that reflects their reducing value. The term given to this consumption is depreciation. This revision note explains the various methods available to calculate depreciation and highlights how subjective this calculation can be. Other revision notes provide worked example of each depreciation method.

Depreciation Methods

The total amount to be depreciated over the life of a fixed asset is determined by the following calculation:

Cost of the fixed asset less residual value

The period over which to depreciate a fixed asset is known as the "useful economic life" of the asset

So how much of this depreciable amount is charged against profits in each accounting period?

A depreciation method is required to allocate, in a systematic way, the total amount to be depreciated between each accounting period of the asset's useful economic life.

There are various methods of depreciation available. However, most businesses appear to adopt one of the two methods described below.

Method 1 - Straight-line depreciation

The straight-line method of depreciation is widely used and simple to calculate. It is based on the principle that each accounting period of the asset's life should bear an equal amount of depreciation.

As a result, the depreciation charge for the asset can be calculated using the following formula:

Dpn = (C- R)/ N

where:

Dpn = Annual straight-line depreciation charge

C = Cost of the asset
R = Residual value of the asset
N = Useful economic life of the asset (years)

Whilst it is simple and popular, Is the straight line depreciation method the most appropriate way of calculating depreciation?

The answer lies in understanding that depreciation is a process of allocation, not valuation.

The pattern of annual depreciation charges for a fixed asset should attempt to match the pattern of benefits derived from that asset. Therefore, where the benefits from an asset are likely to be reasonably constant over its life the straight-line method of depreciation would be appropriate as it results in a constant annual depreciation charge.

In practice it may be difficult to assess the pattern of benefits relating to an asset. In such cases the straight-line method may often be chosen simply because it is easy to understand and calculate.

Method 2 - Reducing balance method

The reducing balance method of depreciation provides a high annual depreciation charge in the early years of an asset's life but the annual depreciation charge reduces progressively as the asset ages.

To achieve this pattern of depreciation, a fixed annual depreciation percentage is applied to the written-down value of the asset. Thus, depreciation is calculated as a percentage of the reducing balance.

For certain fixed assets, the benefits derived may be high in the early years, but may decline as the asset ages. For such assets, the reducing-balance method of depreciation would be appropriate insofar as it matches the depreciation expense with the pattern of benefits.

Once a particular method of depreciation has been chosen for a fixed asset, the method should be applied consistently over its life. It is only permissible to switch from one method to another if the new method provides a fairer presentation of the financial results and financial position.

Total depreciation charged

It should be noted that, whichever method of depreciation is selected, the total depreciation to be charged over the useful life of a fixed asset will be the same.

It is simply the allocation of the total depreciation charge between accounting periods that is affected by the choice of method.

Click here to see a worked example of depreciation using the straight line method

Click here to see a worked example of depreciation using the reducing balance method