Author: Jim Riley Last updated: Sunday 23 September, 2012
Depreciation of fixed assets
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.
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
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
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
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
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,
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
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.