The method we have used above, spreading the cost less residual value evenly over the time period, is known as straight line depreciation. This is the easiest method of depreciation to use and is common in practice.
The rate of depreciation is usually expressed as a percentage, e.g.
Spreading cost less residual value over 4 years, we have used a rate of 25% 25% x (£20,000 - £2,000) = £4,500 |
Often in calculating the depreciation charge for a year any residual value is ignored and the rate is just applied to the cost of the asset. e.g. [{m}.{s}a]
2004 | 2005 | 2006 | 2007 | 2008 | |
Cost/NBV | £20,000 | £15,000 | £10,000 | £5,000 | £0 |
Depreciation charge | £5,000 | £5,000 | £5,000 | £5,000 |
Using this method the value of our asset is reduced to £nil after 4 years. (This is sometimes left at a nominal £1, depreciating by £4,999 in year 4).
Note that if this asset was not scrapped until year 6 there would be no depreciation charge in year 5 as the asset was already fully written-off.
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The other commonly used method of depreciation is the reducing balance method. Here the depreciation rate is applied not to the original cost (or cost less residual value) but to the net book value (NBV). Let us apply a rate of 25% using the reducing balance method, to our asset which cost £20,000 in 2004. |
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2004 | 2005 | 2006 | 2007 | 2008 | |
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Start | £20,000 | £15,000 | |||
Depreciation | (£5,000) | ||||
End | £15,000 |
Cost 2004 | 20,000 |
Depreciation 2004 | 5,000 |
NBV at end 2004 | 15,000 |
At this point NBV=cost. The NBV at the end of 2004 = the start of 2005
2004 | 2005 | 2006 | 2007 | 2008 | |
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Start | £20,000 | £15,000 | £11,250 | ||
Depreciation | (£5,000) | (£3,750) | |||
End | £15,000 | £11,250 |
Depreciation 2005 | 3,750 |
NBV at end 2005 | 11,250 |
Depreciation for 2005 = 25% x £15,000 = £3,750
The NBV at the end of 2005 = the start of 2006
2004 | 2005 | 2006 | 2007 | 2008 | |
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Start | £20,000 | £15,000 | £11,250 | £8,438 | |
Depreciation | (£5,000) | (£3,750) | (£2,812) | ||
End | £15,000 | £11,250 | £8,438 |
Depreciation 2006 | 2,812 |
NBV at end 2006 | 8,438 |
Depreciation for 2006 = 25% x £11,250 = £2,812
The NBV at the end of 2006 = the start of 2007
2004 | 2005 | 2006 | 2007 | 2008 | |
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Start | £20,000 | £15,000 | £11,250 | £8,438 | £6,328 |
Depreciation | (£5,000) | (£3,750) | (£2,812) | (£2,110) | |
End | £15,000 | £11,250 | £8,438 | £6,328 |
Depreciation 2007 | 2,110 |
NBV at end 2007 | 6,328 |
Depreciation for 2007 = 25% x £8,438 = £2,110
The NBV at the end of 2007 = the start of 2008
If we wished to calculate the NBV of the forklift after 4 years using reducing balance depreciation, we could calculate each year in turn as we have just done. Alternatively, we could use a formula:
NBV = Cost x (1 - r)n | Where r = depreciation rate (as a decimal) n= number of years |
eg Cost £20,000
Depreciation Rate = 25% Reducing balance i.e. 0.25
Number of years = 4
NBV = £20,000 x (1 - 0.25)4
= £20,000 x (0.75)4
= £20,000 x 0.3164
= £6,328
Note that using reducing balance depreciation, the depreciation charged in earlier years is greater than that charged in later years. This can be argued as being the more realistic situation as the cost to the business is greater when the asset is newer.
Note also that, using the reducing balance method, the NBV at the end of 2007 is £6,328 compared with £2,000 (or £0 if we do not include a residual value) using the straight line method, with the same percentage of 25%.
Thus, to get to the same residual value after a period of years, a much higher percentage must be used, with the reducing balance method.
With reducing balance depreciation the NBV will gradually get smaller and smaller, never quite reaching zero. In our example the NBV would be £2,000 after 8 years, £1,126 after 10 years.
There are other methods of calculating depreciation, but straight line and reducing balance are the commonly used ones.
2004 | 2005 | 2006 | 2007 | 2008 | ||
Straight line | Start | £20,000 | £15,500 | £11,000 | £6,500 | £2,000 |
Depreciation | (£4,500) | (£4,500) | (£4,500) | (£4,500) | ||
End | £15,500 | £11,000 | £6,500 | £2,000 | ||
Reducing balance | Start | £20,000 | £15,000 | £11,250 | £8,438 | £6,328 |
Depreciation | (£5,000) | (£3750) | (£2,812) | (£2,110) | ||
End | £15,000 | £11,250 | £8,438 | £6,328 |
In the UK it is up to the business to use whatever depreciation method and rate it thinks is appropriate.
Note that the net book value of an asset is not an estimate of its market value. It is best thought of as being the value to the business. The main objective of applying depreciation is to match the cost of the asset against the incomes that it is helping to generate, not to reduce the value of the asset to its market value.
In some countries the depreciation rates for specific categories of assets are fixed. The business must use the specified rate for calculating its depreciation.
Note that in the UK, even though the business can use whatever rates it wishes, these figures will not be allowed for tax purposes. For the computation of tax, the depreciation is recalculated using specific rates (capital allowances).
In our examples in this module, we are applying depreciation annually. This is usually the situation for small businesses where the depreciation charge will be one of the final adjustments required (along with stock, accruals and prepayments) before the preparation of the annual accounts.
In applying annual depreciation, it is usual to depreciate an asset for the full year even if it came into use during the year.
e.g. Asset purchased 30 June 2009 for £10,000. Accounting year end 31 December 2009. Depreciation rate 25% straight line. |
Depreciation charge 2009: 25% x £10,000 = £2,500 even though the asset was in use for only half the year. |
Correspondingly, if an asset is disposed of during the year, depreciation will not usually be charged in that year.
In practice, however, most reasonably sized businesses will prepare accounts monthly for management purposes. To get a realistic figure for the monthly profit, adjustments must be made on a monthly basis.
Thus a depreciation charge will be put through each month. In this case the asset will usually be depreciated in the month it was purchased but not in the month of disposal.
In our examples in this module we will consider only annual depreciation. Exactly the same entries will be made, however, for monthly depreciation - the only difference will be the figures used.
Also in our examples of straight line depreciation we will not, in general, take account of any residual value.