Depreciation of fixed assets
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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.
It will important to read
out following chapters:
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.
You are required to suggest:Managing Capital And Financial Assets
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