Ever
wondered how businesses spread the cost of their assets over time? Let’s break
down depreciation methods—straight-line to reducing balance—and see how they
impact profits and planning!"
Key terms
Depreciation is the fall in the financial value of non-current assets over time due to wear and tear, or obsolescence.
Depreciation is a non-cash expense that is recorded in
the profit and loss account in order to determine profit before interest
and tax. The same amount is
deducted from the non-current asset in the balance sheet
( statement of financial position)
Amortization is the process of allocating the cost of an
intangible asset (e.g., patents, copyrights, trademarks, etc.,) over its useful
life in systematic portions. It reflects the consumption or usage of the asset.
The Straight-Line Depreciation - this is the simplest and most commonly used
method for allocating the cost of a fixed asset evenly over its useful life. It
assumes that the asset provides equal value or utility in each accounting
period.
The Units of Production depreciation method is a way to allocate the cost of a non-current
asset over its useful life based on its actual usage, activity, or output,
rather than time.
Residual value or scrap value is
an estimate of the non-current asset at the end of its useful life. Residual
value is deducted while calculating the amount of depreciation.
Intangible
assets are non-current assets that do not exist in a
physical form but are of monetary value and generated revenue such as goodwill,
copyrights, trademarks, patents, etc.
Causes of depreciation of non-current assets
There are a number of reasons why a non-current
asset (fixed asset) can decrease in value over time. Two key reasons are:
Wear and tear: Factories and equipment are used in production, and
working parts will deteriorate or be damaged over time. This damage and
deterioration is called wear and tear. This is perhaps the most common cause of
depreciation.
Obsolescence:
Obsolescence occurs when the technology used in the
asset has been surpassed by more recent innovations. Over time, machinery will
be replaced by new and more efficient machines. For example, the widespread use
of computer technology in production has meant that equipment purchased even a
few years ago rapidly becomes obsolete.
Methods of Depreciation
The Straight Line Method (SLM) is one of the simplest and most commonly used methods of depreciation. It allocates an equal amount of depreciation expense to an asset for each year of its useful life.
Formula
Annual Depreciation Expense=
Cost of Asset- Residual Value/ Useful Life of Asset
Example: A company purchases machinery for $50,000, with a residual value of $5,000 and an estimated useful life of 5 years.
Annual Depreciation=
$50 000-$5000/ 5 years = = 9,000 per year
So,
the company will depreciate the machinery by $9,000 each year.
Features
Uniform
Depreciation: The same amount is charged every year.
Simplicity:
Easy to calculate and implement.
Ideal
for Fixed-Usage Assets: Best suited for assets that
generate consistent benefits over time.
Advantages
Predictability:
Fixed annual depreciation makes budgeting and forecasting straightforward.
Ease
of Calculation: Requires minimal effort and is easy to
understand.
Widely
Accepted: Commonly used for financial reporting and tax
purposes.
Disadvantages
Unrealistic
Assumption: Assumes equal utility of the asset
every year, which may not reflect real usage or wear and tear.
Overstates
Value: This can lead to overstating an asset’s value in
the early years if it depreciates faster.
Not
Suitable for All Assets: Inefficient for assets that lose
value more rapidly in the initial years, such as vehicles or technology.
Do it yourself!
Exercise 1: City Taxi bought a new taxi for a city tour at a
cost of $ 12 000. The taxi has an
estimated residual value of $ 4000 and an estimated useful life of 5
years. Calculate the amount of annual depreciation. Show your working( Ans: $1600 p.a.)
Exercise 2: Tech Mac Manufacturing( TMM) purchased a machinery for $50,000 with an expected residual value of $5,000 and a useful life of 10 years. Calculate what is the value of the machine after three years of its use. Show your working ( Ans: $36 500)
Units of
Production Method of Depreciation
The Units of Production (UoP) method depreciates an asset
based on its actual usage, output, or activity level. This method ties
depreciation directly to productivity rather than the passage of time, making
it ideal for assets whose wear and tear are closely related to usage.
A company buys a machine for $40,000, with a residual value
of $5,000. The machine is expected to produce 100,000 units during its
lifetime. In the first year, it produces 20,000 units.
Depreciation for the First Year: 0.35×20,000=7,000
The depreciation expense for the first year is $7,000.
Features
Usage-Based: Depreciation aligns with the actual usage or output of the
asset.
Variable Depreciation: The amount fluctuates each year depending on production
levels.
Fair Value Representation: Reflects an asset's wear and tear more accurately for
production-intensive assets.
Advantages
Accuracy:
Matches depreciation to the asset's actual usage, providing a realistic expense
allocation.
Cost Control: Helps businesses monitor the cost of production relative to
the asset's depreciation.
Fair Reporting: Suitable for assets whose value depends on output, such as
manufacturing equipment.
Disadvantages
Complexity: Requires detailed tracking of usage or production data,
which may be time-consuming.
Variable Expense: Depreciation fluctuates, making budgeting and financial
forecasting less predictable.
Not Suitable for Time-Based Assets: Ineffective for assets that depreciate over
time regardless of usage, such as buildings.
This method is particularly useful for businesses in
manufacturing or industries where asset usage varies significantly
year-to-year. However, it is less practical for assets with consistent utility
or where tracking production is challenging.
Do it
yourself!
Exercise 1: A company purchases a machine for
$100,000. The machine is expected to have a residual value of $10,000 and a
total production capacity of 200,000 units. During the first year, the machine
produces 50,000 units. Calculate the amount of depreciation for the first year( Ans: $22 500)
Exercise 2: A company purchases a delivery truck
for $120,000. The estimated residual value of the truck is $20,000. The truck
is expected to have a total useful mileage of 200,000 miles. During the first
three years, the truck covers the following mileage:
Year 1: 40,000 miles, Year 2: 50,000 miles, and Year 3: 60,000 miles
Task:
Determine the depreciation expense for each of the three years.(Ans: $ 20
000, $25 000, $ 30 000)
Record the total accumulated depreciation after three years. ( Ans:$75
000)
Differences
Download the worksheet
Differences Between Straight Line Method and Units of Production Method
| Aspect | Straight Line Method (SLM) | Units of Production Method (UoP) |
|---|---|---|
| Depreciation Basis | Allocates depreciation evenly over the asset's useful life. | Depreciation is based on actual usage or production output. |
| Depreciation Amount | Fixed and predictable each year. | Varies depending on the asset's usage or production. |
| Suitability | Best for assets with consistent utility over time (e.g., buildings). | Ideal for assets whose wear depends on usage (e.g., machinery). |
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