Methods of Depreciation

By definition, fixed assets are those which will provide services over a number of years and the matching convention tells us that we should recognizse the expense in the same period £ as we recognise the associated revenue. Thus we must not write off, or expense, the whole cost of the asset in the period in which the asset is acquired, but should instead convert the asset into an s expense over its life. This gradual conversion is known as depreciation.

How should we compute the depreciation charge for each year? An obvious way would be to compare the current value of an asset at the end of the year with its value at the start of the year and say that the difference is depreciation. But as we have already emphasised, traditional accounting practice is based to on historic cost and not current values; consequently that method is generally not acceptable. The traditional approach is to estimate the total expenditure to be written off, i.e. the cost of the asset less its estimated scrap value, and then to write off that expenditure over the estimated life of the asset by using one of the methods that we shall describe.

It would be helpful to look at a simple example. If a firm purchased a machine on 1 January 199X for £ 22,000, which is expected to last for four years and then be sold for € 2,000:

Cost - £ 22,000

Estimated residual value - £ 2,000_______

Amount to be written off 4 years - £ 20,000

The life of the asset is usually measured in time, but in some instances may be measured on the basis of actual usage.

Depreciation on the basis of 'actual usage' is rare.

In order to consider the difficulties inherent in estimating the life of an asset we should think about the reasons why most fixed assets, other than land, have a limited life. These reasons may be classified as physical wear and tear, and obsolescence. Obsolescence may be of the asset itself, e.g. a new machine may make the use of the original asset, an older machine, uneconomic because the new machine is faster or requires less labour. Obsolescence may also be caused by the object produced by the asset, if, for example, it goes out of fashion. In the latter case, the degree of obsolescence will depend on the specific nature of the asset; some assets may be easily adapted to alternative uses while others may have only one use, the original.

None of the above variables can be determined with any accuracy; obsolescence, in particular, is rapidly increasing in importance because of rapid changes in technology.

Deciding how much should be written off and over what period is not the only problem, for there are a number of depreciation methods from which to choose. A firm's management must decide which one to employ, and a user of financial statements who wishes to compare the financial performance of a number of companies must appreciate the effects of the various methods.

In practice we find two main methods of depreciation – the straight-line basis and accelerated depreciation. There is another method, the annuity method which takes account of the interest costs involved in investing in a long-lived asset; this method has many theoretical attractions but is rarely used.

• Heading 1

The total expected cost is simply spread over the number of years of expected 50 service giving the amount of depreciation expense per annum:

Original cost minus expected residual value Expected number of years in use

• Heading 2

With these methods the depreciation charge in the earlier years of use is greater 55 than in the later years.

Accelerated methods include (a) the Sum of the Years' Digits Method and (b) the Reducing Balance Method.

• Heading 3

Let ‘n’ be the asset's life; the years are each represented by a digit: 1, 2, 3, 4, . . . n. Having fixed on n, the digits are summed and the fractions of the asset cost are charged to the years in reverse order so that the earlier years are charged more than the later years.

• Heading 4

Here the depreciation charge for each year is a fixed percentage of the 'net amount' of the asset (cost less accumulated depreciation to date) at the start of the year.

1. There are two main headings and two subsidiary headings in this text, marked as Headings 1-4. Referring to the text, decide firstly which of the four headings are main and which are subsidiary. Then locate each one in its correct place in the text (i.e. 1-4).

Heading	Main or subsidiary?	Place in text
1. The reducing balance method
2. Accelerated methods
3. Straight-line basis
4. Sum of the years' digits method

2. Finish the following sentences with the ending which agrees most closely with the text.

1) Accounting convention requires that the cost of fixed assets:

a. be matched to the period in which they provide income

b. be extended over the year when they are bought

c. be spread over a period greater than their working life

d. be written off as a one-time expense

2) It is not acceptable to measure depreciation as value at purchase minus present value because:

a. only scrap value can be estimated with any degree of accuracy.

b. one year is too short a period to calculate loss in value.

c. the conventions of accounting base values of assets on costs at the time they were purchased.

d. it is too difficult to estimate current value.

3. Say whether the following statements are true or false according to the text.

1) The cost of an asset is usually written off over a period of time.

2) Depreciation is never calculated on the basis of how much an asset is used.

4. Complete these sentences about obsolescence using only information contained in the text.

1) Obsolescence is one of two reasons why_________

2) Obsolescence can be caused either because _________ or because______.

3)______ decides how obsolescent a change in fashion for its product makes it.

5. Scan the extract about depreciation and the information about Paradigm Ltd.

Of course, some assets such as machinery and equipment lose their value over time because they wear out and become obsolete and out of date. Amounts relating to this are shown as depreciation or amortization in the accounts. For example, some computer equipment is depreciated or amortized over a very short period, perhaps as short as three years, and a charge for this is shown in the accounts. The value of the equipment is written down or reduced each year over that period and written off completely at the end. The amount that is shown as the value of an asset at a particular time is its book value. This may or may not be its market value, i.e. the amount that it could be sold for at that time. For example, land or buildings may be worth more than shown in the accounts because they have increased in value. Equipment may be worth less than shown in the accounts because its value has not been depreciated by a realistic amount.

• Paradigm has goodwill, in the form of hundreds of satisfied customers, worth an estimated $15,000. This is its only intangible asset.

• It has investments of $6,000 in other companies.

• It has raw materials, unfinished goods and finished goods together worth $3,500.

• It owns equipment and machinery with a book value of $9,000.

• It owns land with a book value of $31,000.

• It has $11,000 in its accounts at the bank.

• It owns offices and factories with a book value of $94,000.

• Various people and organizations, including customers, owe $7,500.

6. Using the information above, decide if these statements about Paradigm's assets are true or false.

1) The figure for equipment and machinery is the price it was bought for, written down by an amount for depreciation.

2) The figure for equipment and machinery shows that it has been written off completely.

3) The figure for land and buildings is the exact amount they could definitely be sold for.

4) The figure for goodwill is an objective value of the customer base that a buyer of the company would definitely agree to pay.

DEVELOPING VOCABULARY

1. Look at how the following words are used in the text ‘Methods of Depreciation’. Then put each word into one of the sentences below, using the correct grammatical form.

convention, associated, compute, scrap, residual, inherent, determined, appreciate, takes account of, accumulated

1) Usually obsolescent machinery has to be _________.

2) Trying to _________ future costs at a time of growing inflation is difficult.

3) Rules which are generally followed but are not obligatory are _________.

4) Given their shortage of foreign exchange, there are ________ difficulties in trading with Eastern Europe.

5) ________ the taxes of self-employed workers can be very complex.

6) Any sensible system of taxation must ________ the need to encourage business enterprise.

7) The difficulties of exporting are sometimes not ________ by companies wishing to expand.

8) Together with the income produced by a new product there are _______ costs.

9) Owing to its inefficient management, the company _________ debts £10,000,000 up to now.

10) After a company has paid a dividend there is a _________ amount known as retained profits.

2. Match each definition on the right with a term from the list of words. Write the term beside each definition (the first has been done for you).

capital gains tax corporation tax creative accounting excise duty

income tax loophole money laundering progressive tax

tax deductable tax evasion tax heaven tax loss

tax shelter value added tax

1) income tax People pay this tax on the money they earn.

2) _______ Companies pay this tax on their profits.

3) _______ Profits from the sale of assets may be subject to this tax.

4) _______ Government tax on things such as cigarettes, alcohol and petrol.

5) _______ This kind of tax means that the more money you earn, the higher the rate of tax you have to pay.

6) _______ A clever but still legal way of reducing the amount of tax to an absolute minimum.

7) _______ A country such as Liechtenstein and the Bahamas where tax is low.

8) _______ A mistake in the law which allows people to avoid paying tax.

9) _______ These payments are not subject to tax.

10) _______ In the accounts the company is seen to make this if capital expenditure is brought forward to use up profits.

11) _______ This tax is added to the price of goods and services.

12) _______ Avoiding paying tax by giving false information to the authorities.

13) _______ Investment schemes which allow people to postpone paying tax.

14) _______ Handling money made from illegal activity.

3. Circle the ‘odd one out’ in each of the following.

1) Fixed assets could include

a) buildings c) the firm's delivery vans

b) plant and machinery d) fuel for the vans

2) Depreciation due to physical deterioration of an asset may include

a) wear and tear b) theft c) erosion d) rot

3) Machinery becomes obsolete due to

a) new technology c) changes in production methods

b) consumption d) changes in fashion

4) Amortization is the provision for consumption of the following items

a) mortgages b) leases c) patents d) copyright

5) A provision for depletion would be used for the following items

a) mines b) buildings c) quarries d) oil wells

6) The following are methods of depreciation

a) straight-line c) the sum of the year's digits

b) reducing balance d) market value

7) A machine could be disposed of by being

a) scrapped b) resold c) revalued d) traded in

8) The accounts which would record the sale or disposal of a machine are

a) machinery account c) machinery disposals account

b) sales account d) provision for depreciation (machinery) account

DISCOVERING LANGUAGE

1. Complete the text by inserting the correct form of the verbs:

allow, exist, convert, charge, increase, spread, deduct, involve, wear out, encourage, lose, write off

Fixed assets such as buildings, plant and machinery (but not land) gradually (1) ........... value, because they (2) ........... or decay, or because more modern and efficient versions are developed.

Consequently, they have to be replaced every so often. The cost of buying or replacing fixed assets that will be used over many years is not (3) ........... from a single year's profits but is accounted for over the several years of their use and wearing out. This accords with the matching principle that costs are identified with related revenues. The process of (4) ........... an asset into an expense is known as depreciation.

Various methods of depreciation (5) ..........., but they all (6) ........... estimating the useful life of the asset, and dividing its estimated cost (e.g. purchase price minus any scrap or second-hand value at the end of its useful life) by the number of years. The most usual method of depreciation is the straight line method, which simply spreads the total expected cost over the number of years of anticipated useful life, and charges an equal sum each year. The reducing or declining balance method (7) ........... smaller amounts of an asset's value each year in cases where maintenance costs for the use of an asset are expected to (8) ............ over time. The annuity system of depreciation (9) ........... the cost of an asset equally over a number of years and (10) ........... this, and an amount representing the interest on the asset's current value, each year.

Some tax legislations (11) ........... accelerated depreciation: writing off large amounts of the cost of capital investments during the first years of use; this is a measure to (12) ........... investment.

Note:

In the US, the word amortization is sometimes used instead of depreciation.

2. Add appropriate words to these sentences:

1) A worn out or obsolete machine has to be ............

2) Land, unlike machines, usually appreciates - i.e. it ........... in value.

3) To depreciate an asset accurately, you have to ........... its useful life.

4) The materials that make up an obsolete machine can be recycled if it is sold for ............ .

5) A percentage of the value of fixed assets is ........... against or ........... from the profits,

and becomes a source of funds.

6) Writing off value means ........... it.

7) Keeping a machine in good working condition is called ............ .

8) Accelerated depreciation allows firms that make capital investments to pay less ............ .

3. Replace the words in brackets in each of the following sentences with a phrasal verb of similar meaning. Choose from the following and make any necessary changes.

carry on catch on clear up close off draw up go over look up

sell off set aside set out turn out write off

1) As the machine had no scrap value, they simply (recorded as worthless) wrote it off .

2) The methods used for depreciating the fixed assets should be (displayed) _______ in the notes at the end.

3) Despite massive losses this year, the firm intends to (continue) _______ trading.

4) They found the true value of the land when the firm had to (dispose of) _______ it _______.

5) We think it is best to (keep available) ______ money each year for future investment in new equipment.

6) The estimated life of the assets (proved) ______ to be very accurate.

7) If you cannot remember the formula for the reducing balance method of depreciation, (find in a book) _______ it _______.

8) It's a good idea to (consider)__________the different ways of depreciating assets

before deciding on one particular method.

9) After disposal of the asset you can (finish) _________ the account.

10) The surplus or deficiency is transferred when you (prepare) _______ the Profit and Loss Account.

11) The sum of the year's digits method of depreciation is beginning to (become popular)_______ in Europe now.

12) A change in the method of depreciation should (solve) _______ the problem of allocating costs.

Note: Phrasal verbs consist of a verb together with a preposition or an adverb. There are two possible word orders for phrasal verbs containing an adverb: verb-pronoun/noun-adverb or verb-adverb-noun

write it/the machine off write off the machine

clear it/the problem up clear up the problem

sell it/the land off sell off the land

look it/the formula up look up the formula

4. Translate parts of the sentences in brackets into English, paying attention to modal verbs and infinitive.

1) Changes in economic welfare (могут быть) more definitely indicated by changes in real income per head, while changes in the GNP – (следует относить к) changes in population.

2) As the company is increasing its revenue, the stockholders' dividends (должны быть) higher this year.

3) Under strong demands for higher standards of living the government (вынуждено увеличить) rates of economic growth.

4) As a factor of production labour (должен соединяться с) capital and land in the production cycle.

5) Quite early in his history man (вынужден был искать) some com­modities which (могли использоваться) as a medium of exchange.

6) The government (должно определить) a minimum standard of living and it (следует обеспечить) for every household or individual.

7) The workers and the employers (должны были подписать) an agreement to avoid lower output and the revenue.

8) An individual (может поставлять) the services of different factors of production. He (может поставлять) either labour services through work, or capital services by renting machinery, or the services of land by renting property.

9) It is important to calculate physical depreciation preliminarily in order to know when equipment (должно быть заменено).

10) Proper investment (следует сделать) in human capital as it results in technical improvement of products and production processes.

FOCUS ON FUNCTIONS