IBBusiness ManagementHLRevision Notes3. Finance & Accounts3.4 Final AccountsDepreciation Methods

Depreciation Methods (HL IB Business Management)

Revision Note

Flashcards
Lisa Eades

Understanding Depreciation

  • Depreciation is an accounting technique which recognises that the value of fixed (non-current) assets falls over time
    • It reflects wear and tear, the reduction in an asset's value as it ages or obsolescence

  • Two common methods of calculating depreciation include

    • Straight line depreciation

    • Units of production depreciation

  • Whichever method a business selects, the goal is to allocate the historic cost of the asset in a way that reflects its reduction in value over time
     

Reasons for Calculating Depreciation

Accurately calculate the businesses value

Plan effectively for the replacement of assets

Realistically reflect the performance of assets in financial statements

  • As assets depreciate their current value is recorded in the balance sheet
    • Historic cost is an inaccurate measure as time goes by
    • Provides an accurate representation of capital employed

  • Understanding the depreciation rate of assets helps a business to budget for future replacements
    • Avoid sudden financial strain
    • Schedule replacements to avoid disruption to production

  • Depreciation is an expense recorded in the income statement
    • Reduces reported operating profit
    • Provides an accurate representation of a businesses financial performance

Straight Line Method

  • The straight line method reduces the value of an asset by the same value each year of its useful life

  • Three key variables are required to calculate the annual rate of depreciation of an asset
    • Life expectancy
      • The number of years it is expected to be used before it will need to be replaced
    • Residual value
      • The scrap value of the asset at the end of its useful life
    • Historic cost
      • The initial cost of purchasing the asset

  • The annual rate of depreciation is calculated using the following formula

Annual space depreciation space equals space fraction numerator Historic space cost space minus space Residual space Value over denominator Life space Expectancy end fraction

Worked example

Luftig Tours sells hot air balloon flights in the Salzburg area of Austria. The company recently paid €280,000 for a new balloon. Its life expectancy is anticipated to be 7 years. Its residual value is forecast to be €52,500

Calculate the annual rate of depreciation of the new hot air balloon 

(2 marks)

Step 1: Deduct the residual value from the historic cost

space € 280 comma 000 space space minus space space € 52 comma 500 space equals space space € 227 comma 500      (1)

 

Step 2: Divide the result by the life expectancy

fraction numerator € 227 comma 500 over denominator 7 space years end fraction space equals space € 32 comma 500    (1)

  • Once the annual rate of depreciation has been calculated, until the end of its life expectancy
    • It is recorded each year as an expense in the income statement
    • The value of the asset is reduced each year by this amount in the balance sheet and is recorded as its book value 

Worked example

Luftig Tours sells hot air balloon flights in the Salzburg area of Austria. The company recently paid €280,000 for a new balloon. Its life expectancy is anticipated to be 7 years. Its residual value is forecast to be €52,500

(a) Calculate the book value to be recorded in the balance sheet for each of the hot air balloon's years of useful life

(4 marks)

(b) Calculate the accumulated depreciation for each year of the the hot air balloon's useful life

(2 marks)

Step 1: Create a table with the following headers

Year Depreciation Book Value Accumulated Depreciation
0      
1      
2      
3      
4      
5      
6      
7      

Step 2: Complete Year 0 with the historic cost

Year Depreciation Book Value Accumulated Depreciation
0 0   €280,000  

Step 3: Calculate Year 1 by deducting the annual rate of depreciation

Year space 1 space equals space € 280 comma 000 space minus space € 32 comma 500 space equals space € 247 comma 500    (2)

Step 4: Record these values in the table

Year Depreciation Book Value Accumulated Depreciation
0 0   €280,000  
1 €32,500 €247,500  

 

Step 5: Calculate Years 2 to 7 in the same way

Year Depreciation Book Value Accumulated Depreciation
0 0   €280,000  
1 €32,500 €247,500  
2 €32,500 €215,000  
3 €32,500 €182,500  
4 €32,500 €150,000  
5 €32,500 €117,500  
6 €32,500 €85,000  
7 €32,500 €52,500  

(2)
 

Step 6: Calculate accumulated depreciation by adding the annual rate of depreciation each year

Year Depreciation Book Value Accumulated Depreciation
0 0   €280,000  0
1 €32,500 €247,500 €32,500
2 €32,500 €215,000 + €32,500 = €65,000
3 €32,500 €182,500 + €32,500 = €97,500
4 €32,500 €150,000 + €32,500 = €130,000
5 €32,500 €117,500 + €32,500 = €162,500
6 €32,500 €85,000 + €32,500 = €195,000
7 €32,500 €52,500 + €32,500 = €227,500

(2)

Strengths and Weaknesses of the Straight Line Method

  • The main benefit of the straight line depreciation over other methods is that it is simple to calculate 
  • In many countries it is preferred for tax purposes as it allows for a consistent deduction of depreciation expenses over the asset's useful life
     

The Main Strengths and Weaknesses of Using Straight Line Depreciation 


Strengths
Weaknesses

  • Simplicity

    • Straightforward calculations make it a practical method for small businesses or assets with a predictable decline in value

  • Doesn't Reflect Actual Usage

    • If an asset is heavily used in the early years and experiences less use later on this method may not accurately represent its true value

  • Equal Allocation

    • Suitable when the asset's usefulness is expected to decline steadily over time

  • Market Value Ignored

    • Some assets - such as vehicles - depreciate rapidly in the early years and more slowly/not at all in later years

  • Stability

    • Predictability can be helpful for budgeting and financial planning

  • Mismatch with Reality

    • May not match the actual wear and tear of an asset leading to an inaccurate representation of its value

Units of Production Method

  • The units of production method depreciates an asset based on its usage or production output during an accounting period (usually a year)
    • It is commonly used for assets that wear out based on the number of units produced or hours of operation rather than the passage of time
    • Vehicles commonly lose value as their mileage increases
    • Machinery wears out as it is used in production 

  • The units of production calculation involves two steps

    • Step 1: Calculate the depreciation per unit

Depreciation space per space unit space equals space fraction numerator Historic space cost space minus space Residual space value over denominator Expected space units space over space asset apostrophe straight s space lifetime end fraction

 

    • Step 2: Calculate the depreciation per time period (year)

Depreciation space per space time space period space equals space Depreciation space per space unit space cross times space Number space of space units space produced

Worked example

Emilio's Pizzeria purchased a new pizza oven for $22,600

It expects the pizza oven to last for 12,000 hours before it needs to be replaced

It will be sold for scrap for $4,000 after 4 years

(a) Calculate the depreciation expense if Emilio's Pizzeria uses the pizza oven for 2,900 hours in the first year

(3 marks)

Step 1: Calculate the depreciation per unit

fraction numerator Historic space cost space minus space Residual space value over denominator Expected space units space over space pizza space oven apostrophe straight s space lifetime end fraction equals space fraction numerator $ 22 comma 600 space minus space $ 4 comma 000 over denominator 12 comma 000 space hours end fraction equals space $ 1.55    (2)

 

Step 2: Calculate the depreciation for the time period

Depreciation space per space unit space cross times space Number space of space units equals space $ 1.55 space cross times space 2 comma 900 space hours equals space $ 4 comma 495    (1)

  • Once the depreciation total has been calculated
    • It is recorded as an expense in the income statement
    • The value of the asset is reduced by this amount in the balance sheet and is recorded as its book value 

Strengths and Weaknesses of the Units of Production Method

  • This method is more complicated to calculate than the straight line method
  • It is more likely to reflect the true running costs of non-current assets such as machinery
     

The Main Strengths and Weaknesses of Units of Production Depreciation


Strengths
Weaknesses

  • Depreciation expenses match actual usage of the asset
    • Particularly useful when an asset's wear and tear are directly related to its level of production

  • Calculation can be complex
    • Especially when measuring actual usage is difficult or when production levels fluctuate

  • Reflects the asset's actual value
    • Machinery in manufacturing experiences more depreciation when used more intensively

  • Financial statements less predictable
    • Inconsistent depreciation expenses each accounting period as it is directly tied to production levels

When to use each Depreciation Method

  • The method chosen to depreciate a fixed asset depends on a range of factors, such as
    • Whether the asset is likely to become obsolete
    • Whether the asset is directly used in production
    • Whether its value is closely linked to the amount it is used
       

Appropriate Situations for each Depreciation Method


Straight Line Method
Units of Production Method

  • Most appropriate when
    • The asset's value is unlikely to change due to obsolescence
    • A small business is valuing assets
    • Assess are of relatively low value
    • Assets have a predictable lifespan

  • Most appropriate when
    • The asset's value is linked to its amount of use
    • Assets are valuable and need to be valued with precision
    • A manufacturing business is valuing assets

Exam Tip

Some assets appreciate over time

Increasing land and property values should also be recorded in the final accounts

  • Usually recorded as extraordinary income in the profit & loss account
  • Higher non-current (long term) asset value is recorded in the balance sheet
  • Businesses should take a cautious approach in appreciating the value of these assets
  • It may be deemed fraudulent to misrepresent their value in final accounts - especially if this value is used as leverage to obtain finance
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Lisa Eades

Author: Lisa Eades

Lisa has taught A Level, GCSE, BTEC and IBDP Business for over 20 years and is a senior Examiner for Edexcel. Lisa has been a successful Head of Department in Kent and has offered private Business tuition to students across the UK. Lisa loves to create imaginative and accessible resources which engage learners and build their passion for the subject.