Study Notes: Business Finance & Accounting

Depreciation - straight line example

Introduction

In our introduction to the methods available to calculate depreciation, we suggested that there are two main methods that can be used:

- Straight- line depreciation

- Reducing balance method

We emphasised the point that these two methods simply provide an alternative way of allocating the total depreciation charge over several accounting periods. The total depreciation charge using either method will be the same over the total useful economic life of the asset.

To illustrate the straight line depreciation method, we have calculated the depreciation charge for the following asset:

Data

A business purchases a new machine for £75,000 on 1 January 2003. It is estimated that the machine will have a residual value of £10,000 and a useful economic life of five years. The business has an accounting year end of 31 December.

Straight line depreciation method

Using the straight line depreciation method, the calculation of the annual depreciation charge is as follows:

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)

So the calculation is:

Dpn = (£75,000 - £10,000) / 5

Dpn = £13,000

in the accounts of the business a depreciation charge of £13,000 will be expensed in the profit and loss account for each of the five years of the asset's useful economic life.

In the annual balance sheet, the machine would be shown at its original cost less the total accumulated depreciation for the asset to date.

Example of how this would be disclosed in the accounts

At the end of the third year of ownership of the machine, the financial accounts of the business would include the following items in relation to the machine:

In the Profit and Loss Account:

Depreciation of Machinery - Charge: £13,000

In the Balance Sheet at 31 December 2005:

The figure for accumulated depreciation of £39,000 at 31 December 2005 represents three years' worth of depreciation at £13,000 per year.

The cost of the machine (£75,000) less the accumulated depreciation charged on the machine (£39,000) is known as the "written-down value" ("WDV") or "net book value" ("NBV").

it should be noted that WDV or NBV is simply an accounting value that is the result of a decision about which method is used to calculate depreciation. It does not necessarily mean that the machine is actually worth more or less than the WDV or NBV.

To compare the straight line method with the "reducing balance" method, we have provided a worked example using the same data in the following revision note.