DEPRECIATION

Depreciation is an estimate in amount for the wear and tear of a non-current asset used in a business for its day-to-day operations. It is a part of the original cost of such asset that is consumed during its period of use by the business and it is represented in the statement of profit or loss as an expenditure, calculated as a fraction of the total cost of the asset.

The two most common methods of calculating depreciation are;

·       Straight line method

·       Reducing balance method

 With straight line method of depreciation, the total value of the asset less any residual value (if any) is written off evenly over the estimated life of the asset.  

Annual depreciation charge =  Cost – Estimated residual value

Useful economic life of the asset

With reducing balance method of depreciation, a fixed percentage is charged on the cost of the asset in the first year and subsequent years, the same fixed percentage is charged on the current net book value of the asset. 

Annual depreciation charge in Year 1 = Cost x fixed %

Annual depreciation charge in Year 2 and subsequent years = Net Book Value x fixed %

Exercise:

An equipment has been purchased by a business at the cost of £60,000 and it is to be depreciated at 25% using reducing balance and straight line methods of depreciation.

Calculate the annual depreciation charge for the non-current asset for the first two years.

Answer:

Reducing balance depreciation

Straight line depreciation

Year 1

25% x £60,000= £15,000

25% x £60,000= £15,000

NBV= £60,000-£15,000= £45,000

NBV= £60,000-£15,000= £45,000

Year 2

25% x £45,000= £11,250

25% x £60,000= £15,000

NBV= £45,000-£11,250= £33,750

NBV= £45,000-£15,000= £30,000

So you will see that the depreciation value will start to reduce
where the reducing balance method is used but the depreciation value will remain the same across 4 years where the straight line method of depreciation is used.