Chapter 35- depreciation

Question 1

What is the concept of depreciation?

Answer 1

• allows for the simple fact that a fixed asset will be less of value over time

Question 2

What does depreciation take into consideration and what does it do with the costs?

Answer 2

• they take into consideration that fixed assets may have a life of several years but aren’t worth the same value throughout their lifetime
• they spread the costs of the assets over its lifetime

Question 3

What allows for a more realistic statement of the financial status of the business in terms of its profits and value?

Answer 3

• spreading the cost of the fixed assets over the life of the asset

Question 4

Where does the value of fixed assets appear?

Answer 4

• in the statement of financial position as a fixed asset from which is subtracted the depreciation (sometimes written as ‘less depreciation’)

Question 5

Depreciation terminology
Net book value

Answer 5

• it is the cost minus the amounts that have been written off as it wears out (depreciates)

Question 6

Depreciation terminology
Life of an asset

Answer 6

Life of asset will be affected by:
- amount of wear and tear which depends upon the level of its usage
- whether or not the product or machine becomes technologically obsolete
- demand for the product or machine (market obsolescence)

Question 7

Depreciation terminology
Accumulated depreciation

Answer 7

• this is the addition of the depreciation for each year

Question 8

Depreciation terminology
Residual value

Answer 8

• represents the value of the asset at the end of its useful life
• it’s an estimate of what the asset could be sold for at this time

Question 9

Depreciation terminology
Historic cost

Answer 9

• the initial cost of the asset is calculated as an historic cost because the actual cost at the time of purchase is used

Question 10

What are the two main depreciation methods?

Answer 10

1. Straight line method
   - in which an equal amount is taken off the value of the asset on an annual basis
2. Declining balance method
   - where the asset is reduced in value by a constant percentage on an annual basis

Question 11

Straight line method

Answer 11

• this is the simplest method of depreciation to calculate and apply
• it is the method that is used most frequently
• the cost of the asset is equally spread over its life
  E.g.
• a machine that costs 120,000 has an expected or estimated life of 10 years and a residual value of 20,000 the depreciation for each year would be:

Initial cost - residual value/ life of asset

120,000 - 20,000/ 10
100,000/10= 10,000

• as a consequence the 10,000 would be written off the value of the asset for ten years of its life

E.g.
year 1- 120,000 - 10,000 = 110,000

After ten years the net book value is also the residual value

• using the straight-line graph it is easy to see the net book value at any time during the life of the asset

Question 12

Advantages of straight-line depreciation method

Answer 12

• the amount of depreciation is lower in the first few years compared to the reducing balance method
• by having a lower level of depreciation, there is a higher valuation of the asset on the statement of financial position, suggesting that the value of the business is higher compared to the reducing balance method
• because less is deducted for depreciation, the profit of the business will be higher in the early years of the asset

Question 13

Disadvantages of straight line depreciation method

Answer 13

• an estimate of the residual value is required which for many assets is difficult to gauge
• it assumes that the life of the assets is known, which may not be the case
• having a lower amount of depreciation in the first few years can be misleading; the value of the business may appear inflated

Question 14

Reducing (declining) balance method

Answer 14

• it applies a constant percentage rate of depreciation each year
• not the same as a constant amount- straight line method
• applying this method of depreciation means that a higher amount of depreciation is subtracted from the value of the asset in the early years of its life
• a higher amount is more realistic and allows for the fact that in the later years in the life of the asset additional costs may be incurred to help maintain it and repair possible breakdowns
• the declining balance still allows the business to spread the costs throughout the life of the asset
• gradient is not constant and is much steeper in the early years

Question 15

Advantages of declining balance

Answer 15

• this method reflects more realistically the value of assets that lose value significantly in the early years (such as lorries, cars, aeroplanes)
• no estimate of the residual value is required

Question 16

Disadvantages of declining balance

Answer 16

• with a higher level of depreciation in the early years, the valuation of the assets is lower on the statement of financial position
• lower valuation of assets may make it harder to borrow against assets