Depreciation Methods (DP IB Business Management)

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Lisa Eades

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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

$Annual depreciation = \frac{Historic cost - Residual Value}{Life Expectancy}$

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

$€ 280, 000 - € 52, 500 = € 227, 500$ (1)

Step 2: Divide the result by the life expectancy

$\frac{€ 227, 500}{7 years} = € 32, 500$ (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

(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

$Year 1 = € 280, 000 - € 32, 500 = € 247, 500$ (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

$Depreciation per unit = \frac{Historic cost - Residual value}{Expected units over asset' s lifetime}$

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

$Depreciation per time period = Depreciation per unit \times Number of units produced$

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

$\frac{Historic cost - Residual value}{Expected units over pizza oven' s lifetime} = \frac{$ 22, 600 - $ 4, 000}{12, 000 hours} = $ 1.55$ (2)

Step 2: Calculate the depreciation for the time period

$Depreciation per unit \times Number of units = $ 1.55 \times 2, 900 hours = $ 4, 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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Depreciation Methods (DP IB Business Management)

Revision Note

Understanding Depreciation

Straight Line Method

Worked Example

Worked Example

Strengths and weaknesses of the straight line method

Units of Production Method

Worked Example

Strengths and weaknesses of the units of production method

When to use each Depreciation Method

Exam Tip

Author: Lisa Eades