3.4 Depreciation (HL)

Define Depreciation

Depreciation refers to the fall in the value of a non-current asset. As a non-current asset is used over and over, its value drops due to wear and tear, or eventually becomes outdated as newer models of the asset may become available, causing the value to decrease.

-can also say Depreciation is listed as an expense on the statement of profit and loss

extra:

• failing to account for depreciation will over value the firm’s non-current assets

Explain the Straight line Method for calculating depreciation, state equation

The straight line method is the most straightforward way of calculating depreciation. Linear, so the non-current asset falls by the equal amount each year, spreading the depreciation evenly over the useful life of the non-current asset.

Net book Value:

Value of the asset that is recorded in the balance sheet

Net book value = Original Cost of asset - depreciation

Annual depreciation = (Purchase Cost - Residual Value) / Estimated Useful Lifespan

Explain the advantages of the Straight line method

• The ease of calculating depreciation, as the same amount is deducted each each year. This means depreciation is treated as a fixed cost and does not change with the level of output or production.

• It is suitable for depreciating assets that have a known useful shelf-life and can be estimated accurately

• It is also suitable for assets that have a consistent usage rate over the lifetime of the asset

• It is also easier to depreciate the value of assets until their scrap value is zero

• As the same amount is charged to the profit and loss account each year, it is easier to make historical comparisons of the data

Explain the disadvantages of the straight line method

• Many non-current assets, such as technology depreciate in value the most during the initial stages of their useful shelf life. Hence, using a linear depreciation value can be misleading and inaccurate

• In addition, many assets do no depreciate consistently as they become less efficient over time due to wear and tear. The depreciation expense also does not account for the higher maintenance costs of the non-current asset over time

• It is not suitable or useful if the functional life span of the asset cannot be estimated accurately

• Scrap values are only estimates of the future value of the asset. This makes the provisions for depreciation less accurate