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As over time businesses assets will lose their value, businesses need to
reflect this in their accounts. Depreciation is the tool used by accountants
to record the reduction in the original value of an asset.
Depreciation allows for this through calculations. It is in the balance sheet
under fixed assets and in the profit and loss account as a cost to the
Straight Line Method: It assumes that the net cost of an asset should be
written off in equal amounts over the life of the asset. The formula is :
(Original cost residual value) ÷ expected life
Declining Balance Method: This method assumes that the depreciation
charge should be higher in the early years than in the later years of its life.
It assumes that the asset declines at the same percentage each year. It is
calculated by multiplying the net book value of that year by the set
percentage. E.g. 25000 X 0.80 (80%) = new asset worth
General Advantages of Depreciation:
To have accurate accounts. If the original value of the asset was put on
the balance sheet this would overstate the value which would mean
that any financial analysis done on the accounts would be flawed and
To value the business. As the value of a business is based on the
assets owned, an accurate depreciation is needed to value the
business properly. This is needed when selling, for example.
Straight Line Declining Balance
It is simple, as it only requires Not as simple, but not too complex. It
the same amount to be isn't as widely known or used but still
subtracted each year, which accepted.
makes forecasting easier as
depreciation is known far in
Assumes that the life of the It just decreases the value at the
asset is known, which in some same rate each year until the end of
cases it is not. its life.
Gives a lower amount of It reflects the fact that assets lose
depreciation in the first years most of their value in the first years
meaning that the assets will of use giving a more accurate asset
have a higher value on the value.
balance sheet. This could mean The greater amount of
depreciation provided in initial years
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It is useful for assets such as a As for some assets, the more it
lease where the life of an asset ages, the more it requires in
and its residual value is known maintenance and expenses, using
precisely. the declining balance method would
mean that there is a more equal
expense rate for the asset each year.