1. IB Business and Management
3.5 Depreciation (HL Only)

2. Learning Objectives Understand the causes of depreciation
Understand the impact of depreciation on the profit and loss account and balance sheet
Calculate depreciation using the straight line and reducing balance methods
Evaluate the strengths and weaknesses of each method

3. ? Recap Balance Sheet What can you tell me about Balance Sheets?
2 minutes…. Brainstorm all you can remember
Balance Sheet ?

4. Task Which section of the Balance Sheet? Fixed Asset Current Asset
Current Liability
Capital Employed

5. Which section of the Balance Sheet?
A delivery van

6. Which section of the Balance Sheet?
Money invested in the business by the owner

7. Which section of the Balance Sheet?
Shop premises

8. Which section of the Balance Sheet?
Money in the Bank

9. Which section of the Balance Sheet?
A bank loan taken out

10. Which section of the Balance Sheet?
Stocks of goods

11. Which section of the Balance Sheet?
Profits retained in the business

12. Which section of the Balance Sheet?
Creditors

13. Which section of the Balance Sheet?
Cash at premises

14. What is Depreciation?
Depreciation is the reduction of a value of a fixed asset
Do all fixed assets depreciate?
What causes depreciation?

15. Depreciation in Practice

16. Causes of Depreciation
Usage (Wear and Tear)
Time
Obsolescence (due to technology, fashion etc)
Examples?

17. Depreciation and accounts
Depreciation has an impact on both the
balance sheet and profit and loss account of a business

18. Depreciation in Accounts
Calculation of annual depreciation
Reduce value of asset in the balance sheet
Include as an expense on the profit and loss account

19. Depreciation and the Balance Sheet
The balance sheet aims to give a true and fair account of the value of a businesses assets
As the value of fixed assets depreciates this needs to be reflected in the figure shown

20. Balance Sheet – Reminder of the IB structure
Fixed Assets Less Depreciation = Net Fixed Assets

21. Depreciation and the Profit and Loss Account
Capital expenditure should be seen as advanced payment for the use of an asset over a period of time
Although the asset may have been paid for all at once, in its accounts the businesses spreads the cost over a number of years – Why?
This avoids excessive costs recorded in the year of purchase

22. Calculating Depreciation
How do accountants decide how much depreciation to include in the P&L account each year?
Calculating Depreciation

23. Calculating annual depreciation
There are 2 methods you need to be able to use to calculate annual depreciation:
The straight line method
The reducing balance method

24. Before we start…. Some key terms you need to know.
Residual Value
Initial Cost
Annual Depreciation
Book Value
Useful Life
What do you think these terms mean?

25. Straight Line Method Annual Provision for Depreciation=
The Straight line method involves reducing the value of the asset evenly over it’s useful life.
The yearly depreciation is calculated by:
Annual Provision for Depreciation=
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐶𝑜𝑠𝑡 −𝑅𝑒𝑠𝑖𝑑𝑢𝑎𝑙 𝑉𝑎𝑙𝑢𝑒 𝑈𝑠𝑒𝑓𝑢𝑙 𝐿𝑖𝑓𝑒

26. Example A firm buys a delivery van for £15,000 in 2011
They plan to keep the van for 3 years
They estimate that they will be able to sell the van at the end of the 3 years for £8,400
Calculate the yearly depreciation for the van:
£15,000 - £8, = £2,200 per year 3
How will this impact on the book value of the van?

27. Calculating the Book Value
Year
Initial Value
Annual Depreciation
New Book Value 1
15,000
2,200
12,800 2
10,600 3
8,400

28. IB Question Time – 3 mins Have a go at this question: Gemel Ltd
‘Peter examined the figures and pointed out that George had omitted a provision for depreciation of the firm’s fixed assets, which were valued at $ on start-up. He suggested that George worked on the basis of a four-year life for the assets and estimated a scrap value of $ ’
Calculate the annual depreciation assuming a straight line method of depreciation is used.(Show all your working).
[2 marks]

29. Mark Scheme:
SLD = 𝐻𝑖𝑠𝑡𝑜𝑟𝑖𝑐 𝐶𝑜𝑠𝑡 −𝑆𝑐𝑟𝑎𝑝 𝑉𝑎𝑙𝑢𝑒 𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝐿𝑖𝑓𝑒 = $200,000−$40,000 4 = $ p.a. [2 marks] The calculation is accurate and the working shown, although the formula may not be stated. [1 mark] The calculation is accurate but no working shown or inaccurate with appropriate working.

30. Reducing balance method
The reducing balance method involves reducing the value of the asset by a certain percentage each year

31. Example A firm buys a delivery van for £15,000 in 2011
They plan to keep the van for 3 years
They will reduce the value of the asset in the balance sheet by 17.5% each year
How will this impact on the book value of the van?

32. Book value of the asset Year Initial Value Annual Depreciation
New Book Value 1
15,000
2,625
12,375 2
2,166
10,209 3
1,787
8,422

33. IB Question Time – 5 mins Have a go at this question:
Neat Organization
Neat Organization is a leading provider of resort-based budget holidays in Spain for price conscious consumers. As part of its growth strategy, Neat Organization intends to purchase some new coaches. The initial cost of the coaches is $ After 7 years (the predicted useful life of the coaches), the management hopes that they will have enough residual value that can then be used towards purchasing a new fleet.
Calculate the depreciation at 20 % using the reducing balance method for the first 7 years of the coaches (Show all your working).
[3 marks]

34. Year end Workings Depreciation Value of coaches – 1 000 000 1– 1
20 % × 2
20 % × 3
20 % × 4
20 % × 5
20 % ×
81 920 6
20 % ×
65 536 7
20 % ×
[1 to 2 marks] if the correct procedure has been followed but there is an error(s) in the calculation(s). Deduct [1 mark] per error, but do not penalize for errors that have been carried forward. So if two errors have been made and some workings are shown the mark awarded will be [2 marks].
[3 marks] for the correct final value ($ ) and no errors. Some of the workings are shown and some of the calculations are well presented.

35. Evaluating Depreciation methods

36. What difference will this make to the P&L Account and the Balance Sheet in each different year?

37. Key Questions: Which method is more simple to calculate
Which method is more realistic?
What difficulties could there be if using the straight line method?
Which method will lead to a higher value for fixed assets in the first years after the purchase?
Which method will lead to higher profit figures in the first years after the purchase?

38. Homework Complete exercises c-e from sheet
Optional Extension Question:
A firm has bought an asset for £200,000. They estimate it will have a useful life of 3 years after which time it will have a residual value of approximately £100,000. If the reducing balance method is used what % annual depreciation should they use?
Due Date: Monday October 10th