What is depreciation?
Depreciation is the way a business spreads the cost (net of its residual value) of an item of property, plant and equipment over its estimated useful life. It is an application of the accruals concept of accounting as it seeks to match the cost of ownership of the asset with the periods in which the benefit of ownership is received.
There are a number of different ways that a business can calculate the depreciation charge for a year and businesses should consider which method is appropriate for its assets. On this course we shall look at the methods listed below.
- The Straight-Line Method
- The Diminishing Balance Method
- The Units of Production Method
The Straight-Line Method
The straight-line method spreads the cost of ownership evenly over the useful life of the asset. To calculate the depreciation expense for a year we would use the following formula:
Depreciation expense = (Cost – Residual Value)/Useful life
At the start of the year a business bought a machine for £20,000. The business expected to use the machine for 5 years at the end of which it is forecasted to be worth £5,000.
- Depreciation expense = (Cost – Residual Value)/Useful life
- Depreciation expense = (£20,000 – £5,000)/5 years
- Depreciation expense = £15,000/5 years
- Depreciation expense = £3,000 per year
The depreciation and carrying values of the asset over the five years would be as follows:
Using the straight-line method
The straight-line method is appropriate for those assets whose values tend to fall steadily over time. It is commonly used when depreciating assets such as buildings as well as many types of plant and machinery and assets with short lives such as computers and IT equipment.
This method is often expressed as a percentage or as a fraction; for example:
“Depreciation is charged at 20% p.a. on a straight-line basis.” This means that 20% of the depreciable amount will be charged each year as depreciation.
“Depreciation of 1/6th p.a. is charged on a straight-line basis.” This means that 1/6th of the depreciable amount will be charged as depreciation.
The Diminishing Balance Method
The diminishing balance method (also called the reducing balance method) calculates depreciation by applying a fixed percentage each year to the asset’s carrying value.
Depreciation expense = Carrying value x Percentage
A business depreciates its motor vehicles using the diminishing balance method at a rate of 20% p.a. At the start of the year, the business purchased a vehicle for £15,000.
In the first year, the depreciation expense will be calculated by multiplying the cost of £15,000 by 20%; that is, £3,000.
In the second year, the depreciation expense is the carrying value at the start of the year of £12,000 (i.e. £15,000 less £3,000) multiplied by 20%; i.e. £2,400.
In the third year, the depreciation expense is the carrying value at the start of the year of £9,600 (i.e. £15,000 less £3,000 and £2,400). A summary of the depreciation expenses and carrying values is shown below.
Using the diminishing balance method
The diminishing balance method is appropriate for those assets whose value falls most quickly early in its life.
This method is commonly used when depreciating vehicles and equipment.
The Units of Production Method
The units of production method calculate the units produced by an asset in a period as a portion of the total units expected to be produced over the asset’s useful life and then applies this portion to the asset’s depreciable amount.
The depreciation can be calculated by first dividing the depreciable amount (i.e. cost less residual value) by the total number of units to be produced over the asset’s useful life. This will provide a depreciation rate per unit which can then be multiplied by the number of units made each year to calculate that year’s depreciation expense.
A business depreciates its machinery using the units of production method. At the start of the year it purchased a machine for £100,000 which it expects to use in making 360,000 units over its useful life. The machine is expected to be sold for £10,000 at the end of its useful life.
The depreciation rate per unit of production is therefore the cost of £100,000 less the residual value of £10,000 with the result being divided by 360,000 units. This works out at £0.25 per unit.
In its first year, the machine produced 50,000 units. The depreciation would therefore be £12,500 (i.e. 50,000 units x £0.25/unit). In its second year, the machine produced 70,000 units resulting in a depreciation expense of £17,500 (70,000 units x £0.25/unit). In its third year, the machine produced 75,000 units resulting in a depreciation expense of £18,750 (75,000 units x £0.25/unit).
A summary of the depreciation expenses and carrying values of the asset are as follows:
Using the units of production method
The units of production method is not commonly used in the UK but is more popular in some countries such as Germany. Where it is used, it tends to applied to expensive assets with long lives where falls in value are linked more to production levels rather than to the passage of time.
It is sometimes used to depreciate commercial planes where a depreciation rate per mile is calculated.
Calculating depreciation for part of a year
Accountants often have to calculate depreciation for part of a year. This can occur when an asset is purchased or disposed of part-way through a year, or when accounts are being prepared for a period of less than a year.
The most common method used to calculate depreciation for a short period is to calculate the annual charge and then apportion this total for the number of months in question.
A business owns a lorry that is depreciated on a straight-line basis at a rate of £18,000 per year. The lorry is sold 4 months into an accounting year and the business has a policy of charging depreciation in the year of disposal.
The depreciation charge for the 4 month period will be calculated as follows:
- £18,000 /12 months = £1,500 depreciation/month
- £1,500 x 4 months = £6,000 depreciation expense
Choosing how depreciation is applied
The choice of depreciation method and the rate at which it is applied is dependent on the nature of the asset and how it is expected to be used by the business. Many businesses choose to apply the same method and rates for all assets in the same asset class. For example, a business might depreciate all its cars using the diminishing balance method at a rate of, say 20% per year.
Depreciation after the end of an asset’s useful life
Depreciation should not result in an item of property, plant and equipment having a negative carrying value. Where this could happen, the depreciation expense for the year should be reduced.
Are there any types of property, plant and equipment that should not be depreciated?
The vast majority of property, plant and equipment should be depreciated. The one exception to this is land as this (with very few exceptions) has an unlimited useful life.