3.4.4 - Depreciation (HL)

Question 1

Define depreciación

Answer 1

Depreciation is the decrease of the value a fixed asset over time. It is a non-cash expense that is recorded in the profit and loss account in order to determine the net profit before interest and tax.

Question 2

What are 2 reasons assets depreciate

Answer 2

• wear and tear - when fixed assets are repeatedly used its value reduces as more money is needed to maintain them (i.e. computers, cars, machinery)
• obsolescence - when new and improved fixed assets are introduced in the market, the current fixed assets lose their value and become obsolete; they are eventually removed (i.e. software, computers, new version of cars)

Question 3

What are the 2 methods to calculate depreciation

Answer 3

• the straight line method
• units of production method

Question 4

Define straight line method

Answer 4

The straight-line method is a simple and widely used method that spreads out the value of the asset equally over time deducing a given constant amount of depreciation of the asset’s value annually.

Question 5

What are the 3 important variables used for the straight line method calculation

Answer 5

a) The expected useful life of the asset (how long is it intended to be used before it needs replacement)
b) The original cost of the asset (also know as purchase or historical cost)
c) The residual or scrap value of the asset which is an estimation of the asset’s value over it’s useful life, also know as salvage value.

Question 6

What is the formula for annual depreciation

Answer 6

Annual depreciation = original costs - residual valué/ expected useful life of asset

Question 7

How do you calculate net book value

Answer 7

You use a table with 3 columns; year, annual depreciation expense, net book value. The depreciation value will be constant so every year minus that number of the book value and it should match the residual scrap value

Question 8

Solve this problem ;

Using the same data for example 1, calculate the depreciation expense if the van was purchased in August 1st, 2020 with the year ending still on December 31st, 2020.

Answer 8

Depreciation expense = 5 months / 12 months x 35,000 - 5,000/5 years = 2,500

Question 9

What are the advantages of the straight line depreciation method

Answer 9

• Simplest depreciation method to calculate as it is a predictable expense
• Can be applied to all long-term assets. However, it’s mostly suitable for less expensive assets (i.e. furniture). They can be written-off within the asset’s useful life
• It is the same for each period of assets’ service life
• Widely acceptable and usable accounting method

Question 10

What are the disadvantages of the straight line depreciation method

Answer 10

• Does not reflect accurately the difference in usage of an asset from one period to the other. For example, machinery, as it does not consider loss of efficiency or repair of the asset
• Does not necessary match costs with revenues in different types of long-term assets. It could ‘inflate’ the value of some assets that loose more value in the first years (i.e. cars)
• Might not be appropriate for some depreciable assets due to changes in technology (i.e. computers)

Question 11

What are the disadvantages of the straight line method

Answer 11

• Does not reflect accurately the difference in usage of an asset from one period to the other. For example, machinery, as it does not consider loss of efficiency or repair of the asset
• Does not necessary match costs with revenues in different types of long-term assets. It could ‘inflate’ the value of some assets that loose more value in the first years (i.e. cars)
• Might not be appropriate for some depreciable assets due to changes in technology (i.e. computers)

Question 12

What does the units of production calculate

Answer 12

The units of production method calculates depreciation based on the units of usage rather than time (as used for the straight line method). This means that the depreciation expense will be higher during years when the asset is used more and lower during years when the asset is used less.

Question 13

What are the bits of information we need when calculating depreciation with units of production

Answer 13

1. Original Cost of the asset (what was paid for the asset when purchased)
2. The salvage (residual) value of the asset
3. The estimated number of possible units to be produced on the assets’ useful life. This is normally calculated using historical data (of production)
4. Expected useful life of the asset before it needs to be replaced
5. The total number of units that were produced in the year

Question 14

Whats the equation for the units of production rate

Answer 14

Units of production rate = (cost of assets - salvage value) / estimated units of production

Question 15

Whats the equation for calculating depreciation expense

Answer 15

Depreciation expense = Units of production rate × Actual units produced

Question 16

Solve :

a firm has purchased a new photocopier for £5,000 with a scrap value of £500 in 5 years’ time when it is expected to be replaced. The total expected units of production (output from the machine) is 300,000. The firm produced 60,000 units of output from the photocopier in Year 1

Answer 16

●Original Cost: £5,000
●Salvage (residual) value: £500
●estimated number of possible units to be produced: 300,000
●Expected useful life: 5 years
●The total number of units produced in the year: 60,000

• Units of production rate = £0.015
• Depreciation expense = £900 (number put into balance sheet)

Question 17

What are the advantages of the units of production method

Answer 17

1. This is a more realistic method. Specially for businesses that use machinery
2. More accurate for non-current assets that directly depreciate due to “wear and tear” rather that with time.
3. Useful for manufactures that experience a change in production due to changes in demand consumption

Question 18

What are the disadvantages of the units of production method

Answer 18

1. Compared to the straight-line method of depreciation, this method is more difficult to calculate.
2. The “estimated units of production” is just an estimate.
3. It is mainly useful for manufacturers rather than businesses that does not produce a product.
4. Many tax authorities (such as the IRS in the US) do not allow the units of production depreciation method to be used for tax purposes. Hence, this method is primarily used for internal bookkeeping (accounting records).