3.4.4 Depreciation Methods (HL Only) Notes

Depreciation: Methods and Importance

1. Depreciation is the process of allocating the cost of a tangible asset over its useful life.
2. It represents the reduction in the asset’s value due to factors such as wear and tear, obsolescence, or usage over time.
3. Businesses use depreciation to account for asset costs in financial statements and for tax purposes.

Causes of Depreciation

1. Wear and tear
   1. As assets are used over time, gradual deterioration takes place.
   2. This is particularly common in physical assets like machinery, vehicles, and equipment, which experience wear through friction, aging, and exposure to the environment.
   3. As the asset is used, its efficiency declines, resulting in a decrease in its value.
2. Obsolescence
   1. When an asset becomes outdated due to technological advancements or shifts in market demands.
   2. Even if the asset is still functioning, it may lose value as newer, more efficient alternatives become available.

The Two Methods of Depreciation

1. Straight-Line Method

1. The straight-line method is one of the simplest and most widely used depreciation methods.
2. It allocates an equal amount of depreciation to an asset each year over its useful life.

How It Works

1. The assets' cost is spread evenly across its useful life.
2. The formula for calculating annual depreciation is:

$$\text{Annual Depreciation = Cost of Asset} - \frac{\text{Residual Value}}{\text{Useful Life (in years)}}$$

1. Cost of Asset: The initial purchase price.
2. Residual Value: The estimated value of the asset at the end of its useful life.
3. Useful Life: The number of years the asset is expected to be used.

Advantages and Disadvantages

1. Advantages:
   1. Simple to calculate and understand.
   2. Provides a consistent expense each year, making budgeting easier.
2. Disadvantages:
   1. Assumes the asset loses value evenly, which may not be realistic for all assets.
   2. Does not account for higher maintenance costs in later years.

Units of Production Method

1. The units of production method bases depreciation on the asset's actual usage or output rather than time.
2. This method is particularly useful for assets whose value is closely tied to how much they are used.

How It Works

1. Depreciation is calculated based on the number of units produced or hours used.

Formulae for Units of Production Method

$$\text{Depreciation per unit = Purchase cost } - \frac{\text{scrap value}}{\text{expected number of units produced over lifetime}}$$

$$\text{Depreciation expense = Depreciation per unit} \times \text{Number of units produced}$$

Advantages and Disadvantages

1. Advantages
   1. Aligns depreciation with actual usage, providing a more accurate reflection of the asset's wear and tear.
   2. Useful for assets with unpredictable usage patterns.
2. Disadvantages
   1. Requires detailed tracking of usage or output.
   2. More complex to calculate compared to the straight-line method.

Comparing the Two Methods

Choosing the Right Method

1. Straight-Line Method is appropriate when:
   1. The asset's usage is consistent over time.
   2. Simplicity and ease of calculation are priorities.
   3. The asset's value does not fluctuate significantly due to technological changes.
2. Units of Production Method is suitable when:
   1. The asset's value is closely tied to its usage.
   2. Accurate tracking of usage or output is feasible.
   3. The asset experiences variable usage over its life.