There is a number of different methods accountants can use to calculate depreciation of Fixed Assets in Balance Sheet.
Among them, there are two main methods of calculating depreciation that are widely used by accountants around the world:
- Straight-Line Method
- Reducing Balance Method
The annual depreciation is calculated using three key variables:
- Purchase cost of the asset.
- Expected lifespan of the asset. How long it is intended to be used before it needs to be replaced?
- Residual value of the asset. How much it is worth at the end of its useful life?
What Is Depreciation of Fixed Assets?
Let’s take a closer look at how depreciation is calculated.
1. Straight-Line Method
Straight-Line Method of Depreciation is the simplest and most commonly used of the two methods; popular amongst European companies.
This method depreciates the value of an asset by a predetermined amount for the duration of its useful life – reduces the value of an asset by the same amount each year.
The Net Book Value of the asset is calculated by deducting the accumulated depreciation from the historic cost, the purchase cost of the asset.
Net Book Value = Purchase Cost of the Asset –Depreciation
The following formulae are used to calculate depreciation using Straight-Line Method.
Scenario A: The asset has no residual value at the end of its life.
The following formula is used:
Depreciation = Purchase Cost of The Asset / Expected Lifespan of The Asset (in years)
Example 1:New computers were bought for USD$50,000 and are expected to last ten years, when they will be replaced. The annual depreciation is a fixed amount of USD$5,000 per year. The Net Book Value at the end of each year and at the end of the expected lifespan of the asset is shown below:
Year
1
2
3
4
5
6
7
8
9
10
Depreciation
$0
$5,000
$5,000
$5,000
$5,000
$5,000
$5,000
$5,000
$5,000
$5,000
$5,000
Net Book Value
$50,000
$45,000
$40,000
$35,000
$30,000
$25,000
$20,000
$15,000
$10,000
$5,000
$0
Scenario B: The asset has some residual value at the end of its life.
The residual value is an estimate of the scrap or disposal value of the asset at the end of its useful life. Many firms simply use a zero-residual value since estimates may prove to be inaccurate. However, it is unusual for a Fixed Asset to lose all of its value because it can fetch a minimal price when sold.
The following formula is used:
Depreciation = (Purchase Cost of The Asset – Residual Value of The Asset) / Expected Lifespan of The Asset (in years)
The formula given above is then used to calculate the annual depreciation charge.
Example 2:New computers were bought for USD$50,000 and are expected to last ten years, when they will be replaced.After ten years, the computers are expected fetch a second-hand value of USD$10,000. Then, the annual amount of depreciation is worked out as USD$4,000 per annum. There is a difference of USD$1,000 each year compared with the depreciation charge, if there is no residual value.
Year
1
2
3
4
5
6
7
8
9
10
Depreciation
$0
$4,000
$4,000
$4,000
$4,000
$4,000
$4,000
$4,000
$4,000
$4,000
$4,000
Net Book Value
$50,000
$46,000
$42,000
$38,000
$34,000
$30,000
$26,000
$22,000
$18,000
$14,000
$10,000
The amount of depreciation will be included in the firm’s overhead expenses in . And this annual depreciation charge will also be subtracted from the value of equipment under Current Assets in Balance Sheet.
Straight-Line Method – Evaluation
The key advantage of Straight-Line Method is that it is simple to understand and calculate.Hence, widely used by different limited companies.
However, depreciating Fixed Assets by the same amount each year throughout the asset’s lifespan is not very realistic. Many assets such as cars and trucks as well as computers and other IT equipment lose a much larger percentage of their value at the beginning of their lifespan due to fast advances in modern technology. Straight-Line Method does not reflect that as all depreciation charges are the same every year while the repairs and the maintenance costs of an asset tend to increase with age.
2. Reducing Balance Method
Reducing Balance Method of Depreciation is the more realistic one of the two methods; popular amongst U.S. companies.
This method depreciates the value of an asset by a predetermined percentage for the duration of its useful life. This reduces the value of an asset by a larger amount in the earlier year.
The Net Book Value of the asset is calculated by deducting the accumulated depreciation from the historic cost, the purchase cost of the assets.
Net Book Value = Purchase Cost of the Asset –Depreciation
The following formula is used to calculate depreciation using Reducing Balance Method:
Depreciation = Depreciation Rate (%) x Cost of the Asset(in a given year)
Example 3:New computers were bought for USD$50,000 and are expected to last ten years, when they will be replaced. The business chose to use Reducing Balance Method to depreciate the computers at an annual depreciation rate of 10%. This time, annual depreciation is not a fixed amount per year. The value of the asset at the end of each year is shown below. This method also leaves a residual value ofUSD$17,434 forthe computers after ten years.
Year
1
2
3
4
5
6
7
8
9
10
Depreciation
$0
$5,000
$4,500
$4,050
$3,645
$3,281
$2,952
$2,657
$2,392
$2,152
$1,937
Net Book Value
$50,000
$45,000
$40,500
$36,450
$32,805
$29,524
$26,572
$23,915
$21,523
$19,371
$17,434
Reducing Balance Method – Evaluation
The key advantage of Reducing Balance Method is that it ismore realistic in representing the rate of falling market value of Fixed Assets over time. It depreciates the asset at the faster rate in the first few years of the asset’s lifespanthan in later years.
However, Reducing Balance Method is not as straightforward to calculate. And, it can be subjective in deciding on the annual rate of depreciation, unless specified by law. Also, it is unnecessary if the firm aims to spread the whole cost of an asset over its total useful lifespan.
In practice, it does not really matter which method is used to calculate depreciation. But, in order to allow for meaningful and historical comparisons, it is vital to be consistent in the choice of the method used.
As a seasoned financial expert with extensive experience in accounting and financial management, I've worked with various companies, providing strategic financial guidance and ensuring accurate financial reporting. I have a comprehensive understanding of accounting principles and methodologies, including the calculation of depreciation for fixed assets.
In the realm of fixed asset accounting, two prominent methods stand out: the Straight-Line Method and the Reducing Balance Method. These methodologies are widely adopted by companies worldwide, each with its own set of advantages and considerations.
Let's delve into the key concepts discussed in the article:
1. Depreciation of Fixed Assets:
- Definition: Depreciation is the systematic allocation of the cost of a fixed asset over its useful life. It reflects the decrease in the asset's value due to wear and tear, obsolescence, or other factors.
2. Straight-Line Method:
- Overview: This method evenly distributes the depreciation expense over the asset's useful life.
- Formula (No Residual Value): Depreciation = Purchase Cost / Expected Lifespan
- Formula (With Residual Value): Depreciation = (Purchase Cost - Residual Value) / Expected Lifespan
-
Evaluation: Simple to understand and calculate, widely used, but may not reflect the actual depreciation pattern for assets prone to rapid technological changes.
Example 1 (No Residual Value):
- Computers purchased for $50,000, expected lifespan of 10 years.
- Annual depreciation: $5,000
-
Net Book Value over 10 years.
Example 2 (With Residual Value):
- Same computers with a residual value of $10,000 after 10 years.
- Annual depreciation: Varies annually.
- Net Book Value over 10 years.
3. Reducing Balance Method:
- Overview: This method applies a fixed percentage to the remaining book value each year, resulting in higher depreciation in the early years.
- Formula: Depreciation = Depreciation Rate (%) x Book Value
-
Evaluation: More realistic in representing the market value decline, but less straightforward to calculate. Annual rate subject to interpretation.
Example 3:
- Computers purchased for $50,000, annual depreciation rate of 10%.
- Annual depreciation varies.
- Net Book Value over 10 years, with a residual value.
4. Evaluation of Methods:
- Straight-Line Method: Simple and widely used but may not align with the actual depreciation pattern for certain assets.
- Reducing Balance Method: More realistic in representing market value decline, but involves subjective rate determination.
5. Consistency in Methodology:
- Regardless of the chosen method, consistency is crucial for meaningful historical and comparative analysis.
In conclusion, while both methods serve their purpose, the choice between Straight-Line and Reducing Balance should align with the nature of the assets and the financial reporting objectives of the company. Consistency in the selected method is paramount for accurate financial analysis and decision-making.
