Methods of calculating depreciation

Methods of calculating depreciation

There are several ways in which depreciation can be calculated. The aim is to match that proportion of the cost of the fixed asset to the revenue earned by it each year. This is not an easy task in reality and many factors must be considered, such as:
How long will the fixed asset last?
How much will be received when the fixed asset is sold at some point in the future?
How can the benefits gained from the use of the fixed asset be measured?
There are three main methods of depreciation:
1. Straight line method      2.Reducing balance method       3.Revaluation method

There are other methods which may be used, but these are outside the scope of our syllabus.

Different types of fixed assets may be depreciated using different methods and using different rates. The method chosen must be the one which spreads the cost of the asset as fairly as possible over the years which benefit from the use of the asset. Once a method has been selected, it should be applied to that asset each year. This is an application of the concept of consistency.

Straight line method of depreciation

This may also be called the fixed installment method. Under this system the same percentage rate is used each year and the amount of the depreciation charged is the same each year. It is used for fixed assets which provide equal benefits to the business each year they are in operation. Using this method, it is possible for an asset to reach a nil value in cases where no residual value is expected. The straight-line method of depreciation is widely used and simple to calculate. It is based on the principle that each accounting period of the asset's life should bear an equal amount of depreciation.

Reducing balance method of depreciation

This may also be called the diminishing balance method. Under this method the same percentage is used each year but, because it is calculated on a different value each year, the amount of depreciation will reduce each year. At the end of the first year the agreed percentage of depreciation is deducted from the cost of the fixed asset. In later years the same percent­age is used, but it is calculated on the cost of the asset less the depreciation already charged (the reduced balance). This means that a higher amount of depreciation will be charged against profits in the early years of the life of the fixed asset. Reducing balance depreciation is used for assets which, in the early years, have lower maintenance costs but give greater benefits than in later years. As the depreciation is always calculated as a percentage of the written-down value (reduced balance) of the fixed asset, the asset will never reach a nil value in the books. Any estimated residual value will be taken into consideration when the percentage rate is decided upon.
 

Revaluation method of depreciation

Sometimes it is not possible to maintain detailed records of certain types of fixed assets. For assets such as very small items of equipment, packing cases, and hand tools it is not practical to maintain full records of each particular asset. Without full accounting records the straight line and reducing value methods of depreciation cannot be operated. In such cases the revaluation method of depreciation is used.

Under this method the assets are valued at the end of each year. This value is compared with the previous valuation (or the cost, if it is the first year of ownership of the asset) and the amount by which the asset has fallen in value is the depreciation for the year.

Formula:

Use of fixed asset (Depreciation) = Value of Fixed Assets at start add Purchases of Fixed Assets during the year Less Value of Fixed Assets at end