Depreciation - Top Study Guide

Depreciation indicates how much of fixed asset’s value has been used up. Machinery the business bought a year ago will not have the same value now. This is because the asset is used in production. Two methods of calculating depreciation:

Straight line method

This method assumes that a fixed asset depreciates by the same value every year.

$Depreciation allowance = \frac{Original cost - Residual value}{Expected life (years)}$

Thus, if a piece of machinery for ABC Ltd. originally costs €28 000 and the residual value is estimated at €4 000 and expected life at 4 years, depreciation allowance would be:

$\begin{array}{l} Depreciation allowance = \frac{€ 28000 - € 4000}{4} \\ = € 6000 \end{array}$

So, how do we see what the value of a fixed asset will be in those 4 years? We make a table, where following the idea of the straight line method, we subtract the same depreciation allowance each year.

This is how you should present it in your exam:

Year	Depreciation Allowance (euro)	Net book value (euro)
0	–	28000
1	6000	22000
2	6000	16000
3	6000	10000
4	6000	4000

Advantages

Simple.
Quick.
Most common, especially in Europe.

Disadvantages

Assumes that the depreciation is linear.
Not realistic for something to decrease at an equal amount each year.

Reducing balance method

This method assumes that the depreciation charge in the early years of an asset’s life should be higher than in later years, which is more realistic. To do this, the asset must be written off by the same percentage rate each year.

Year	Depreciation Allowance (euro)	Net book value (euro)
0	–	28000
1	= 28000 × 40% = 11200	16800
2	= 16800 × 40% = 6720	10080
3	= 10080 × 40% = 4032	6048
4	= 6048 × 40% = 2419	3629