Updated on 18th July 2012 on the meaning of depreciation and provision for depreciation.
This topic requires students to memorize the formula to calculate with each method of depreciation. It should be noted that depreciation only applies to assets (for business purposes only and not for resale) and anything purchased for resale should never be included for depreciation (most often used to trick A level students.)
1) Straight line method (also called fixed installment method)
(Cost – Estimated Disposal Value) / Number of Expected Years of Use
If a motor vehicle was purchased for $25,000 and the estimated disposal value is $5,000, and the number of useful life is 4 years, then,
Depreciation = (25,000 – 5,000) / 4 = $ 5,000 per year.
Therefore, this assets will have to be depreciated for 4 years at $ 5,000 per year (fixed) before this asset will be disposed off.
2) Reducing Balance Method (also called diminishing balance method)
The general formula is presumed to be = Net Book Value x Fixed Percentage Given
*Important terms have to be remembered, failure to understand this usually caused students proceeding to A level having the same difficulty.
Cost means Original Price of an Asset.
Provision for depreciation is the total depreciation used to reduce the amount of fixed assets in the balance sheet.
Depreciation is a one year expense which is brought forward to the profit and loss account.
Net Book Value means value after depreciation.
Assume the same motor vehicle at $25,000. The depreciation is to be charged at 10%.
1st year depreciation will be = $ 25,000 x 0.10 = $2,500
2nd year depreciation will be = $ (25,000 – 2,500) x 0.10 = $2,250
3rd year depreciation will be = $ (25,000 – 2,500 – 2,250) x 0.10 = $2,025
and so on… The first year uses Cost x Percentage only, while the second year and consecutive years use NBV x Percentage.
3) For A level student, Revaluation method (often used in manufacturing account to depreciate loose tools*)
Revaluation = Opening balance + Purchases – Closing balance
The most easiest depreciation method, but most students failed to recall the formula or are unknown of this method.
If the opening balance of a loose tools account amounted to $2,000 and during the year, the business purchased $500 worth of loose tools and at the end of the year, the loose tools accounted to $1,500.
Depreciation = OB + P – CB = $2,000 + $ 500 – $1,500 = $ 1,000.
*Loose tools are a part of machinery (spare parts) which can include things such as nails, tools and etc that is easily lost. There are considered to be a part of the fixed assets and so depreciation applies (to account for loose tools lost or stolen).