Depreciation

Question 1

Explain what is meant by “depreciation”.

Answer 1

Depreciation is the loss in value of a fixed asset (e.g. motor vehicles, machinery) over time for any of the following reasons:
Passing of time i.e. age
Wear and tear i.e. usage
Obsolescence i.e. going out of date/fashion

Question 2

2) Distinguish between the straight line method and reducing balance method of depreciation. Straight Line

Answer 2

Here, the fixed asset is reduced by an equal amount each year. This may be a given percentage e.g. 20% or may be calculated using the following formula:
Cost Price – Scrap Value
Estimated Life Reducing Balance: Here the amount of the depreciation taken off the asset reduces each year as the value of the asset reduces. A fixed percentage of the cost of the asset is calculated in year one and each year after that, the same percentage is applied to the book value of the asset at the end of the previous year.
Example Year 1 – 20% of €50,000 = €10,000 Year 2 – 20% of €40,000 i.e. €50,000 - €10,000 = €8,000 Year 3 – 20% of €32,000 i.e. €40,000 - €8,000 = €6,400

Question 3

3) Explain why a company charges depreciation in calculating profit
A company charges depreciation in calculating profit for the following reasons:
Depreciation is an allowable expense for the business and so they can reduce the profits accordingly and as a result pay less tax
If depreciation was not included, the profits and as a result the company net worth would be overstated and as such would not be a “true and fair view” of the company’s financial position

Question 4

4) Why would a company choose one method of depreciation over another?

Answer 4

A company would choose different methods of depreciation depending on:
Methods they have used in the past – consistency! If the asset is expected to remain in the business in the long term e.g. buildings, they might choose a straight line method If the asset is expected to lose its value in the early years e.g. technology, they might choose a reducing balance method which would result in a greater amount of depreciation being charged in the earlier years of the assets life

Question 5

5) What factors are taken into account in arriving at the annual depreciation charge?

Answer 5

The factors to be taken into account in arriving at the annual depreciation charge are:
Type of asset Estimated life of the asset The cost of asset Method of depreciation to be use