Management Accountancy : Depreciation

Depreciation is a financial “treatment” as in it isn’t actual money being spent or lost as such, but does allow the loss of financial value of an asset to be charted through its life in a series of accounts.

Straight Line method

The most common type of depreciation used and calculated the annual depreciation by taking into account the Purchase Cost (how much the item cost at purchase), Residual Value (Scrap/resale value of the asset after its expected life) and the Expected Life (length in years that the asset was designed/intended for):-

Annual Depreciation = (Purchase Cost – Residual Value)/ Expected Life

e.g. Car (£15,000) – (£5,000) / 5 years = £2,000 depreciation per annum

                Reducing Line Method or Declining Balance Method

The reducing line method of depreciation is less frequently used, although takes into account that the largest amount of depreciation occurs in the first 2 years of owning an asset.  It takes into account the previous years “book value” (i.e. the value that was posted in the Balance Sheet), then removes a percentage of the value.  The method is named reducing/declining method as the value of deprecation drops over the life of the asset.

                Annual Depreciation = (Previous Years value * Rate of depreciation)

                e.g. car purchased for £15,000 with a Reducing Line method of deprecation set at 20%

                End of year 1 (15000 * 0.8) = £12,000 value posted as a NCA (Asset depreciated £3,000 in year)

                End of year 2 (12000 * 0.8) = £9,600 value posted as a NCA (Asset depreciated £2,400 in year)

It is important to note that residual value can be a negative value in the case of items that require scrappage/disposal fees.  An example of such an asset would be a CRT computer monitor which contains lead within the glass of the screen and as such would have to undergo specialist disposal.