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Depreciation (SL & HL) Content P220-222 (Stimpson & Smith, 2012, Business & Management for the IB Diploma Program

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The Straight Line Method (Vs) The Reducing Balancing Method of Depreciation Straight Line Depreciation A constant amount of depreciation is subtracted from the value of the asset each year. Reducing Balancing Method Calculates depreciation by subtracting a fixed percentage from the previous year’s net book value. Net Book Value The current balance sheet value of a non current asset = original cost – accumulated depreciation.

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Straight Line Method of Depreciation To calculate the annual amount of depreciation the following information will be needed: The original or historical cost of the asset. The expected useful life of the asset. An estimation of the value of the asset at the end of its useful life – this is known as the residual value of the asset.

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Straight Line Method Formula The formula: Annual Depreciation Charge = Original Cost of Asset – Residual Value Expected useful life of the assets

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Straight Line Method - Advantages It is easy to calculate and understand. It is widely used by limited companies. Look in the annual account of many limited companies and you will see they are using the straight line method.

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Straight Line Method-Disadvantages It requires estimates to be made regarding both life expectancy and residual value. Mistakes at this stage will lead to inaccurate depreciation charges being calculated. Certain assets – like cars, trucks and computers tend to depreciate more quickly in the 1 st & 2 nd years than in subsequent years. This is not reflected in the straight line method of calculation – all annual depreciation charges are the same. The reducing balance method of depreciation depreciates assets by a greater amount in the first few years of life than in later years. There is no recognition of very rapid pace at which advances in modern technology tend to make existing assets redundant.

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Practical Example Straight Line Method A company purchases a new machine for $9000 It has as residual value of $600. It has an effective life of 4 years. $9000 - $600 = 8400 / 4 = $2100

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Practical Example Straight Line Method YearAnnual Depreciation Charge Net book value of the machine. Present –0$9000 1$2100$6900 2$2100$4800 3$2100$2700 4$2100$600

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Reducing Balance Method of Depreciation This method of calculating depreciation solves some of the problems identified by the straight-line method. It leads to higher levels of depreciation in the early years of an assets life, but lower depreciation as the asset ages. Unlike the straight line method, you will be given a % number which is used to depreciate the asset every year, from the reduced balance. There is a formula for this calculation, but it is easier to understand the process with a practical example.

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Practical Example Reducing Balance Method A delivery company purchases a van for $16,000. The depreciation rate is 30%. The estimated useful life of the van is 4 year.

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Practical Example Reducing Balance Method YearDepreciationNet Book Value 00$16,000 1$4800 ($16,000 x.3) (.3 = 30%)$11,200 2$3360 ($11,200 x.3)$7840 3$2352 ($7840 x.3)$5488 4$1646 ($5488 x.3)$3842 At the end of 4 years, the van is only worth $3842. This is the residual value.

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Reducing Balance Method Advantages It more accurate than the straight-line method especially where assets lose value in their early years. Many assets are more efficient and profitable when new, so it is more logical to “match” a higher amount of cost to the asset against the higher profit.

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Reducing Balance Method Disadvantages By calculating a “precise” rate of inflation its suggests a level of accuracy for the process of depreciation which is unjustified – the residual value and expected life span are always estimates and this distracts from the achievement of complete accuracy.

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Reducing Balance Method - Exercises A company purchases a large item of machinery for $105,000. It has a useful life for 4 years. The depreciation rate is 25% Calculate the annual depreciation amount and the net book value for each year.

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