WJEC Business Studies A Level Resources.

2008 Spec. Issue 2 Sept. 2012

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Depreciation

Specification requirement— Depreciation: its relevance and calculation (straight-line method only).
Most fixed assets used by businesses will decrease in value over time. This decrease in value is known as depreciation. Assets depreciate with use, with age, or as a result of the development of new technology. If assets were not depreciated they would be shown on the business’s Balance Sheet at ‘Historic Cost’, when what is required to show the true value of a firms assets, is a valuation of assets at ‘net book value’.
There are though, some fixed assets that increase in value over time. The two best examples of appreciating assets are land and some buildings.
Example of Depreciation.
A firm buys a computer for £1,000, (historic cost), to be used for designing brochures, direct mail and price lists. Upon purchase it is estimated that the machine will have a useful working life of 4 years, and at the end of this period it will probably have a scrap value of £100. (Firms will generally have to accept standard periods for the depreciation of fixed assets, and these are normally agreed with the tax man). Over the 4 year period the total depreciation of the computer is therefore £900, £1000 buying price less £100 scrap value. Each year the computer will be shown on the firms Balance Sheet as having a lower value ( net book value), until at the end of 4 years, the net book value of the computer will be £100. If the computer is then sold, the asset will disappear for the balance sheet, and the revenue gained from the sale (in this case expected to be £100), will become cash—a current asset. Using the above example of the computer, total depreciation has been £900 over the four years. If we were to divide this amount by 4 we would have annual depreciation of £225.
Calculating Depreciation- The Straight Line Method
The application of an equal amount of depreciation to each year of an assets useful life is known as the straight-line method of depreciation,. This method of depreciation is simple to use, often approved of by the Inland Revenue, and the preparation of depreciation accounts is a straightforward process.
In the diagram below, an asset has been purchased for £10,000, and will depreciate in value over a five year period by £2,000 a year. At the end of year 5 the net book value of the asset is nil.
Residual Value.
It is unusual for an asset to lose all of its value over its useful life to a business. Most assets will have some form of scrap value, or may be sold on to another user. The computer in the example above may be sold to a staff member for a £100.
The net book value of an value asset that remains at the end of the assets useful life is known as the residual value, and when calculating depreciation this residual value needs to be taken into account.
If a van was purchased for £10,000 and has as estimated residual value of £2000 after 5 years, then total depreciation over the 5 year period would be £10000 -£2000 = £8000.
Using the straight line method, depreciation would now be £1600 per year (£8000 divided by 5 years).
Accounting for depreciation.
Depreciation is shown as a business expense on the Profit and Loss Account. Depreciation also affects fixed assets on the Balance Sheet. As existing fixed assets are depreciated each year, the value of existing fixed assets will fall on an annual basis. When assets are re-valued on an annual basis, the Balance Sheet will show assets at their net book value.
Depreciation needs to be accounted for, for 3 reasons:
So that profits are not overestimated.
So that the value of fixed assets is not overestimated
To make accounting provision for replacement purchase of new fixed assets in the future.
Notes

Title Depreciation

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