Methodology Glossary Tier 2
Depreciation
In order that company accounts acknowledge the fact that their fixed assets decline
in value over time, it is necessary to calculate asset depreciation so that it can be
included in the relevant accounts published by the company. The depreciation
charge is shown as an expense in the Profit and Loss account and the current value
of the asset is shown in the company’s balance sheet. There are three main
methods of calculating depreciation and these are outlined below.
Straight-line Method
This is the most simple and commonly used method of calculating depreciation. It is
useful when one knows, or can estimate, what the value of the fixed asset is likely to
be at the end of its useful life. It involves charging an equal amount of depreciation
for each year of the expected use of the asset. The depreciation amount is
calculated as follows:
Depreciation = Cost of Fixed Asset – Residual Value of Asset
Useful Life of Asset (Years)
or
D = (C – R) / n
Example Consider a business that purchases a new machine for £75,000. The
business expects that the machine will have a useful working life of 5 years and
expects that after this time it will be worth £10,000. Using the straight line
depreciation method, the calculation of the annual depreciation charge is as follows:
D = (C – R) / n
= (£75,000 – £10,000) / 5
= £13,000
When the accumulated depreciation is plotted on a chart it forms a straight line.
Value of Machinery Over Time
80000
70000
60000
Value (£)
50000
40000
30000
20000
10000
0
1
Effect of Straight-line Method
2
3
4
Year
5
6
Methodology Glossary Tier 2
The advantages of the straight-line method are that it is easy to use and that it
reflects the fact that the usefulness of most assets is much the same for each year of
their economic lives. The main disadvantage, however, is that it does not usually
reflect the true decline in market value of an asset over its life.
Reducing Balance Method
The reducing balance method is a type of accelerated depreciation because it
imposes a higher depreciation cost earlier in an asset’s lifetime. This approach is
more appropriate when the value of an asset falls more in the earlier years than in
the later years of its useful life. The reducing balance method reflects this situation
by applying a fixed annual depreciation percentage to the book value (original cost)
of the asset which means that the charge is applied as a percentage to a reducing
balance. So while the depreciation percentage remains the same, it is applied to a
reducing balance which means that the actual depreciation charge will be less each
successive year.
A common example of assets which depreciate in this manner is cars. The value of
most cars falls particularly steeply during the first three years or so after purchase
but reduces more slowly thereafter. So it is true to say that a car’s value may fall by
thousands of pounds between years one and two, but that at four years old it may be
only be worth a few hundred pounds more than it is at five years old.
Lets look at the example from the previous section regarding the business who has
purchased a new machine. The business decides to calculate annual depreciation
using the reducing balance method at the rate of 40% of the book value. The table
below shows the depreciation calculations which occur over the five year lifetime of
the machine.
2003
Original machine cost
Depreciation in 2003 (40% of cost)
Written down value at 31 December 2003
£
75,000
30,000
45,000
2004
Depreciation in 2004 (40% of WDV @ 31 December
2003)
Written down value at 31 December 2004
18,000
27,000
2005
Depreciation in 2005 (40% of WDV @ 31 December
2004)
Written down value at 31 December 2005
10,800
16,200
2006
Depreciation in 2006 (40% of WDV @ 31 December
2005)
Written down value at 31 December 2006
6480
9,720
2007
Depreciation in 2007 (40% of WDV @ 31 December
2006)
Written down value at 31 December 2007
3888
5,832
By applying a fixed percentage of 40% of the book value, the value of the machine
decreases by a greater amount in the first few years of its life than in the latter years.
Methodology Glossary Tier 2
This can be seen in the chart below. The effect of depreciating the purchase cost by
40% each year is that 78.4% of the asset value is written off by the end of 3 years
(compared with 52% using the straight line method).
Value of Machinery Over Time
80,000
70,000
60,000
Value (£)
50,000
40,000
30,000
20,000
10,000
0
0
1
Effect of Reducing Balance Method
2
3
4
5
Year
However, if the residual value of an asset is known then the appropriate
depreciation percentage for a set amount of years can be calculated. The formula
would be as follows:
Dp = 1 – n√(R/C)
Where:
Dp = depreciation %
n = useful life of asset in years
R = residual value of the asset
C = cost of the asset
So for the previous example if the written down value of £5832 was known
beforehand, using the depreciation percentage formula the appropriate rate of
depreciation should come to 40% per year.
Consider a car hire company that buys a fleet of ten vehicles at a total cost of
£120,000, with the expectation that it can sell them on after 5 years to a used car
dealer for £ 15,000. Due to the increasing maintenance costs of the fleet resulting
from wear and tear, it decides to mainly write off the purchase cost of the vehicles
during the early years when the maintenance costs are lower. Application of the
reducing balance method using a standard formula indicates the appropriate
depreciation to be 34 %.
The effect of depreciating the purchase cost by 34% each year, is that 71% of the
asset value is written off by the end of 3 years.
The advantage of the reducing balance method is that this approach reflects more
closely the decline in market value of most assets. It is also relatively easy to use.
Methodology Glossary Tier 2
The main disadvantage of this method is the fact that it results in a higher
depreciation charge in the first year than the straight-line method. A higher charge to
the profit and loss account means less profit, and a higher charge against a
departmental budget means less money for other things. Hence, businesses often
prefer to use the straight line method where the depreciation charge is constant.
However, the higher the depreciation charge early in an asset's life, the less likely it
is that there will be a substantial loss upon eventual disposal.
Sum of Digits Method
This is a variation on the reducing balance method which also applies higher
depreciation in the early years of asset life. The exact apportioning of depreciation
over the expected life of the asset is determined by the digits (usually years)
remaining of the asset’s life divided by the sum of digits (usually years).
If an asset has a useful lifespan of 5 years, then its sum of digits is:
5 years + 4 years + 3 years + 2 years + 1 year = 15
So at the start of year one there will be 5 years asset life and the proportion of
depreciation to be applied at the end of the year is:
in year 1
in year 2
in year 3
in year 4
in year 5
5/15 or 0.33
4/15 or 0.27
3/15 or 0.20
2/15 or 0.13
1/15 or 0.07
Referring back to the company buying machinery for £75,000. The effect of applying
the sum of digits method is that 33% of the asset value is written off after one year,
60% after two years, 80% after three. 93% after four and the full £75,000
depreciation after five years.
Year 1
Year 2
Year 3
Year 4
Year 5
Depreciation * 75,000
5/15
4/15
3/15
2/15
1/15
Charge Cumulative Value
25,000
25,000
50,000
20,000
45,000
30,000
15,000
60,000
15,000
10,000
70,000
5,000
5,000
75,000
0
Note
There are several things to be aware of when working with depreciation. Firstly, the
accounting lifespan of an asset can differ from its useful working life. For example,
even though a PC may be worth nothing to the financiers, it can still be in perfect
working order and playing a vital role. Secondly, land and buildings tend to be
treated differently - usually land is accounted for at cost, which means that over time
it will tend to under-estimate the actual value.
Methodology Glossary Tier 2
Value of Machinery Over Time
80000
70000
60000
Value (£)
50000
40000
30000
20000
10000
0
0
Effect of Sum of Digits Method
1
2
3
4
5
Year
Under UK accounting regulations, the depreciation method must be stated in the
organisation’s accounts – it is normally included as a note to the balance sheet
under the heading of ‘Fixed Assets’, as either tangibles or intangibles. Such assets
do not last forever and must eventually be replaced. Any realistic estimation of
profits must include a charge for the use of fixed assets, effectively spreading their
cost over their revenue producing lives.
The useful economic life of a tangible fixed asset is defined as “the period over which
the entity expects to derive economic benefits from the asset”. The following factors
need to be considered in determining useful economic life:




expected usage of the asset;
expected physical deterioration of the asset;
economic or technological obsolescence;
legal or similar limits on the use of the asset.
Whatever method a business uses to calculate its annual depreciation provision,
three factors should be taken into account:



the cost or revalued amount of the asset;
the estimated economic life; and
the estimated residual value of the asset.
While ‘cost’ is known or can be derived, the second and third factors can only be
estimated.
Further Information
Tier 1 Depreciation