Depreciation Methods: Straight-Line and Reducing Balance

Introduction to Depreciation

• Depreciation: The allocation of the cost of a non-current asset over its useful life.
• Applies to assets that have a finite useful life and provide an economic benefit for more than 12 months.
• Depreciation is an expense, representing the portion of the asset’s cost consumed during the period.
• Accrual Basis Assumption: Depreciation ensures accurate profit calculation by matching revenues earned against expenses incurred.
• Relevance: Depreciation provides useful information for decision-making in financial reports (Income Statement and Balance Sheet).

KEY TAKEAWAY: Depreciation is not about the asset physically deteriorating, but about allocating its cost over its useful life to match revenue generation.

Methods of Depreciation

1. Straight-Line Method

• Assumption: The asset contributes evenly to revenue throughout its useful life.
• Application: Suitable for assets with few moving parts (e.g., office furniture, fixtures).

• Calculation: Depreciation expense is the same each year.

  Formula:
  $$Depreciation Expense = \frac{Cost - Residual Value}{Useful Life}$$

  Where:
  * Cost = Original cost of the asset
  * Residual Value = Estimated value of the asset at the end of its useful life
  * Useful Life = Estimated number of years the asset will be used

• Example:

  • Asset: Office Furniture
  • Cost: \$5,000
  • Residual Value: \$500
  • Useful Life: 5 years
  • Annual Depreciation Expense: (\$5,000 - \$500) / 5 = \$900

EXAM TIP: Always clearly state the formula you are using when calculating depreciation in an exam.

2. Reducing Balance Method

• Assumption: The asset contributes more to revenue at the beginning of its life and less as it ages.
• Application: Suitable for assets with moving parts that are more efficient when new (e.g., equipment, vehicles, computers).

• Calculation: Depreciation expense is a percentage of the asset’s carrying value (book value).

  Formula:
  $$Depreciation Expense = Carrying Value \times Depreciation Rate$$
  Where:
  * Carrying Value = Cost - Accumulated Depreciation
  * Depreciation Rate = A percentage

• Example:

  • Asset: Delivery Van
  • Cost: \$32,000
  • Depreciation Rate: 20% per annum

  Year 1:
  * Depreciation Expense: \$32,000 * 0.20 = \$6,400
  * Carrying Value at end of Year 1: \$32,000 - \$6,400 = \$25,600

  Year 2:
  * Depreciation Expense: \$25,600 * 0.20 = \$5,120
  * Carrying Value at end of Year 2: \$25,600 - \$5,120 = \$20,480

COMMON MISTAKE: Forgetting to use the carrying value and mistakenly using the original cost when calculating reducing balance depreciation.

Comparison of Depreciation Methods

STUDY HINT: Create practice problems for both methods. Vary the cost, residual value, useful life, and depreciation rate to see how the depreciation expense changes.

Impact on Financial Reports

• Both methods ultimately allocate the same total depreciation expense over the entire life of the asset.
• Income Statement: Depreciation expense reduces profit.
• Balance Sheet:
  • Non-Current Assets: Shows the original cost of the asset.
  • Accumulated Depreciation: Shows the total depreciation charged to date.
  • Carrying Value: Cost - Accumulated Depreciation.

REMEMBER: The carrying value is also known as the book value of the asset.

Consistency and Comparability

• Comparability: Once a depreciation method is chosen for an asset, it should be consistently applied from one period to the next.
• This allows for meaningful comparison of financial reports over time.
• A business can use different methods for different assets, depending on the asset’s revenue-earning pattern.

APPLICATION: Companies must disclose their depreciation methods in the notes to the financial statements. This allows users to understand how depreciation is calculated and to compare the company’s financial performance with other companies.

Ethical Considerations

• Choice of Method: Selecting a method to deliberately manipulate profit (e.g., choosing reducing balance to reduce profit in early years for tax purposes) is unethical.
• Estimates: Inflating useful life or residual value to reduce depreciation expense is also unethical.
• Transparency: Failing to disclose changes in depreciation methods or significant estimates impairs the reliability of financial reports.

VCAA FOCUS: VCAA often asks about the ethical considerations related to depreciation, so be prepared to discuss the importance of honest and transparent reporting.