Depreciation

Depreciation is a measure of the loss of value of a non- current asset (fixed asset) due to:

  •  wearing out over time
  •  extensive use
  •  assets become obsolete (out-of-date technology)
  •  depletion (assets run out)

How the cost of an asset is charged:

E.g. A car is bought for £15,000 in 2007

Question: How is this shown on the BS a/c. and income statement?

Answer

The full cost of a fixed asset is not charged to the financial accounts in the year it was bought.

Instead, the cost of this fixed asset is split into separate payments and the cost is charged to each year of the product’s life.

Example

A machine costs £250, 000 and is expected to be used for 4 years.

Year 1

£250,000 cash payment.

However, the cost of the machine is deemed to be spread out over the 4 years of its life at £62,500 per year.

Year 1

Depreciation expense on the income statement =

Year 2

Depreciation expense on the income statement =

Year 3

Depreciation expense on the income statement =

Year 4

Depreciation expense on the income statement =

Note:

The annual depreciation expense does not involve any movement of cash.

It is a notional charge to the income statement.

Impact on key accounts

1. IS a/c.

Depreciation spreads the cost of an asset over its lifetime to avoid excessive costs in the year of purchase.

2. BS a/c.

Depreciation shows the reduction in an asset’s value.

Therefore, shows the true value of the asset on the BS each year.

How depreciation is shown on the BS account:

Book value – the BS value of an asset

Net book value = historic cost – accumulated depreciation

Historic cost - the original purchase price paid for an asset.

Accumulated depreciation – depreciation to date

Annual depreciation – annual amount value of asset is reduced by

Straight-line method of depreciation

It reduces the book value of the asset by the same amount each year over the asset’s useful life.

Annual depreciation =

historic cost – original purchase price

residual value – forecast value left in an asset at the end of the useful lifetime.

useful lifetime - expected life time

Example:

Initial purchase price = £10,000

Expect to receive £1,600 on selling after 4 year.

 Calculate the annual provision for depreciation.

Annual depreciation = historic cost – residual value / years of useful life

Questions:

1. An airline depreciates its aircraft over 25 years.  It believes that an aircraft bought for £64 million can be sold at the end of its life for 15 million.

a. What will the annual depreciation charge be?

b. What would the book value of the aircraft be after 10 years?

2. Will increasing the depreciation charged for a year increase or decrease the profit for that year?

To increase profit, annual depreciation should be reduced.  This can be done by increasing useful life or residual value.


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