Topic 10 - Depreciation

 

What is depreciation?

 

Depreciation is the allocation of the cost of a fixed asset over its useful life. It is a revenue expenditure. It will appear in the Profit & Loss Account as an expense.

 

What is net book value?

Net Book Value = Historical Cost – Total Depreciation

 

What are the causes of depreciation?

 

·         WEAR AND TEAR

This is the loss of effectiveness through use.

 

·         OBSOLESCENE

This is the loss of economic effectiveness due to technological advancement or changes of fashion.
 

·         PASSAGE OF TIME

Some assets, such as leasehold property and patent rights, have fixed lives. The worth of such assets decreases with the passing of time.

 

·         DEPLETION

This is the diminishing of natural resources from wasting assets such as mines, quarries and forests.

 

What are the different methods of depreciation?

 

1.    STRAIGHT LINE METHOD

 

Annual Depreciation =

Cost of Fixed Assets - Scrap

Estimated Useful Life

 

Or

 

Annual Depreciation =

x % X Cost of Fixed Assets

 

Rate of Depreciation =

Annual Depreciation     x 100%

Cost of Fixed Assets

 

 

Feature:         equal amount every year
 

Advantage:    easy to calculate
 

Disadvantage: no proper matching if the service is not uniform every year

 

 

2.    REDUCING BALANCE METHOD

 

Annual Depreciation =

x % X Net Book Value of Assets

 

Where

Net Book Value =

Cost - Accumulated Depreciation

 

Feature:         the amount of depreciation per year diminishes with each successive year
 

Advantage:    overall expenses stay constant throughout the asset’s life

Disadvantage:          difficult to calculate; asset will always have a small value left

 

 

3.    REVALUATION METHOD

 

Annual Depreciation =

Cost of Fixed Assets At Beginning – Cost of Fixed Asset At End of Period

 

The revaluation method is normally used for calculating depreciation of items such as loose tools and farmers’ livestock, which are difficult to estimate with any certainty the rate at which the asset will depreciate.

 

Advantage:    This allows for a more realistic financial position to be expressed.

Disadvantage:          A lot of time and effort has to be expended in order to revalue the assets. 

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